Integrated Prudential sourcebook

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PRU 1

Application and general requirements

PRU 1.1

to follow

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to follow

PRU 1.2

Adequacy of financial resources

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Application

PRU 1.2.1

This section applies to an insurer unless PRU 1.2.7 R applies.

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PRU 1.2.2

(1) In relation to liquidity risk only, this section applies to a firm in PRU 1.2.3 R unless PRU 1.2.7 R applies.
(2) Liquidity risk includes the systems, processes and resources required by this section in respect of liquidity risk.

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PRU 1.2.3

The firms referred to in PRU 1.2.2 R (1) are:

(1) a building society;
(2) a bank or an own account dealer (other than a venture capital firm) that is a UK firm;
(3) an incoming EEA firm which:

(a) is a full BCD credit institution; and
(b) has a branch in the United Kingdom;

(4) an overseas firm which is a bank or an own account dealer (other than a venture capital firm) but which is not:

(a) an incoming EEA firm; or
(b) a lead-regulated firm;

(5) an overseas firm which:

(a) is a bank;
(b) is a lead-regulated firm;
(c) is not an incoming EEA firm; and
(d) has a branch in the United Kingdom.

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PRU 1.2.4

For a firm described in PRU 1.2.3 R (3) or PRU 1.2.3 R (5), this section applies only with respect to the branch.

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PRU 1.2.5

This section applies to an incoming EEA firm only to the extent that the relevant matter is not reserved by the relevant Single Market Directive to the firm's Home State regulator.

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PRU 1.2.6

If a firm carries on:

(1) long-term insurance business; and
(2) general insurance business;

this section applies separately to each type of business.

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PRU 1.2.7

This section does not apply to:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) a UCITS qualifier; or
(5) an ICVC; or
(6) an incoming EEA firm (unless PRU 1.2.3 R applies); or
(7) an incoming Treaty firm.

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PRU 1.2.8

The guidance in PRU 1.2 is drafted with respect to a firm to which PRU 1.2 and the other provisions of PRU referred to in PRU 1.2 apply in full. The guidance in PRU 1.2 is also applicable to a firm that falls into PRU 1.2.2 R. However the guidance in PRU 1.2, as it applies to such a firm, should be read accordingly. In particular, the guidance in PRU 1.2 only applies to such a firm in respect of liquidity risk.

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PRU 1.2.9

In the case of an incoming EEA firm that is a full BCD credit institution and of an overseas firm that is a lead-regulated firm, PRU 1.2 only applies to its United Kingdom branch. However, as a branch is not itself a legal entity separate from the rest of a firm, this restriction does not mean that the rest of the firm can necessarily be left out of account when considering compliance with PRU 1.2. For example, the availability of the branch's liquidity resources may be affected by general liquidity problems in the firm. Likewise, there may be liquidity resources elsewhere in the firm that are available to meet liquidity problems in the branch.

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PRU 1.2.10

One factor that may affect the degree to which it is necessary to take into account the firm as a whole is the extent to which the firm manages the liquidity of the branch on an autonomous basis, or includes the branch within integrated liquidity management of the firm as a whole. In the latter case, for instance, the requirement in PRU 1.2.35 R to carry out scenario analyses may be satisfied by the firm meeting similar requirements set by the regulator in its home country in respect of the firm as whole, provided that the firm separately identifies the impacts on the United Kingdom branch of the scenarios analysed. However, in the case of a full BCD credit institution, the application of PRU 1.2 is further restricted by PRU 1.2.5 R.

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PRU 1.2.11

The scope of application of PRU 1.2 is not restricted to firms that are subject to the relevant EC Directives. It applies, for example, to pure reinsurers.

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PRU 1.2.12

The adequacy of a firm's financial resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

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PRU 1.2.13

The requirements in PRU 1.2 apply to a firm on a solo basis.

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Purpose

PRU 1.2.14

This section amplifies Principle 4, under which a firm must maintain adequate financial resources. It is concerned with the adequacy of the financial resources which a firm needs to hold in order to be able to meet its liabilities as they fall due. These resources include both capital and liquidity resources. PRU 2 sets out provisions relating to the adequacy of capital resources. PRU 5 contains provisions relating to liquidity.

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PRU 1.2.15

This section therefore introduces rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, how it intends to deal with those risks, and the amount and nature of financial resources the firm considers necessary. These assessments should be documented so that they can be easily reviewed by the FSA as part of the FSA's assessment of the adequacy of capital resources.

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PRU 1.2.16

This section also introduces rules requiring a firm to carry out appropriate stress tests and scenario analyses for the risks it has previously identified and to establish the amount of financial resources needed in each of the circumstances and events considered in carrying out the stress tests and scenario analyses.

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PRU 1.2.17

The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. This is done, by the FSA, through comparing the firm's capital resource requirements with its capital resources and by review of a firm's processes and systems for assessing capital needs, the results of the firm's assessments, and other information available to the FSA on the risks faced by the firm.

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Outline of other related provisions

PRU 1.2.18

PRU 2.1 sets out the minimum capital resources requirements for a firm. PRU 2.2 sets out how capital resources are defined and measured for the purpose of meeting the requirements of PRU 2.1.

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PRU 1.2.19

PRU 2.3 sets out detailed guidance on how firms could assess the adequacy of their capital resources both to comply with the rules set out in this section and to enable the FSA to assess better whether the minimum capital resources requirements of PRU 2.1 are appropriate. The more thorough, objective, and prudent a firm's capital assessment is and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment. The FSA will consider the appropriateness of the firm's capital assessment to establish the level of capital resources the firm needs. This may result in the FSA's assessment of a firm's capital resources needs being lower or higher than would otherwise be the case.

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PRU 1.2.20

PRU 5.1 sets out general systems and controls provisions for liquidity risk.

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PRU 1.2.21

PRU 1.4 sets out rules and guidance on the establishment and maintenance of systems and controls.

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Main Requirements

PRU 1.2.22

A firm must at all times maintain overall financial resources, including capital resources and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.

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PRU 1.2.23

The liabilities referred to in PRU 1.2.22 R include contingent and prospective liabilities that a firm has potentially incurred. It therefore excludes liabilities that might arise from transactions that a firm has not entered into and which it could avoid, for example, by ceasing to trade. It includes liabilities or costs that arise as a consequence of strategies other than continuing as a going concern. It also includes claims that could be made against a firm, which ought to be paid in accordance with fair treatment of customers, even if such claims could not be legally enforced.

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PRU 1.2.24

A firm should therefore make its assessment of adequate financial resources on realistic valuation bases for assets and liabilities taking into account the actual amounts and timing of cash flows under realistic adverse projections. This does not require a firm to hold financial resources sufficient to ensure that any particular margin of financial resources is maintained under such adverse projections.

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PRU 1.2.25

Risks may be addressed through holding capital to absorb losses that unexpectedly materialise. The ability to pay liabilities as they fall due also requires liquidity. Therefore, in assessing the adequacy of a firm's financial resources, both capital and liquidity needs should be considered. PRU 5.1.86 E is an evidential provision relating to PRU 1.2.22 R concerning contingency funding plans. A firm should also consider the quality of its financial resources such as the loss-absorbency of different types of capital and the time required to liquidate different types of asset.

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PRU 1.2.26

A firm must carry out regular assessments of the adequacy of its financial resources using processes and systems which comply with PRU 1.2.27 R.

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PRU 1.2.27

The processes and systems required by PRU 1.2.26 R must be proportionate to the nature, scale and complexity of the firm's activities.

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PRU 1.2.28

PRU 1.2.27 R amplifies the requirement in SYSC 3.2.6 R.

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PRU 1.2.29

The processes and systems are required for a firm's internal assessment of the adequacy of its financial resources. The appropriateness of the internal process, and the degree of involvement of senior management in the process, will be taken into account by the FSA when reviewing a firm's assessment as part of the FSA's own assessment of the adequacy of a firm's financial resources. The processes and systems should ensure that the assessment of the adequacy of a firm's financial resources is reported to its senior management as often as is necessary. In addition, a firm would be expected to reassess the adequacy of its financial resources should the firm experience some material change to the nature or scale of its activities.

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PRU 1.2.30

The assessments undertaken by firms in run-off may not need to be as comprehensive or frequent compared to a firm not in run off since this may better reflect the reduced nature and complexity of its business and reduced access to new capital. Whilst a firm in run-off will still need to carefully monitor the progress of the run off, a more comprehensive assessment may only be appropriate on commencement of the run off or when considering a reduction in capital through the payment of a dividend or other capital distribution or if the firm's circumstances change materially.

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PRU 1.2.31

The processes and systems required by PRU 1.2.26 R must enable the firm to identify the major sources of risk to its ability to meet its liabilities as they fall due, including the major sources of risk in each of the following categories:

(1) credit risk;
(2) market risk;
(3) liquidity risk;
(4) operational risk; and
(5) insurance risk.

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PRU 1.2.32

In PRU 1.2.31 R:

(1) operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events; and
(2) insurance risk refers to the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

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PRU 1.2.33

The processes and systems required by PRU 1.2.26 R must enable the firm to carry out an assessment of how it intends to deal with each of the major sources of risk identified in accordance with PRU 1.2.31 R.

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PRU 1.2.34

Certain risks such as systems and controls weaknesses may not be adequately addressed by, for example, holding additional capital and a more appropriate response would be to rectify the weakness. In such circumstances, the amount of financial resources required to address these risks, which may not be adequately addressed by holding additional capital, will be zero. However, a firm must, in accordance with PRU 1.2.37 R, document the approaches taken to manage these risks.

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PRU 1.2.35

For each of the major sources of risk identified in accordance with PRU 1.2.31 R, the firm must carry out stress tests and scenario analyses that are appropriate to the nature of those major sources of risk, as part of which the firm must:

(1) take reasonable steps to identify an appropriate range of realistic adverse circumstances and events in which the risk identified crystallises; and
(2) estimate the financial resources the firm would need in each of the circumstances and events considered in order to be able to meet its liabilities as they fall due.

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PRU 1.2.36

Stress tests and scenario analyses should be carried out at least annually. A firm should, however, consider whether the nature of the major sources of risks identified by it in accordance with PRU 1.2.31 R and their possible impact on its financial resources suggest that such tests and analyses should be carried out more frequently. For instance, a sudden change in the economic outlook may prompt a firm to revise the parameters of some of its stress tests and scenario analyses. Similarly, if a firm has recently become exposed to a particular sectoral concentration, it may wish to add some stress tests and scenario analyses in order to reflect that concentration. PRU 5.1.61 E is an evidential provision relating to PRU 1.2.35 R concerning scenario analysis in relation to liquidity risk.

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PRU 1.2.37

A firm must make a written record of its assessment of the adequacy of its financial resources, including:

(1) the major sources of risk identified in accordance with PRU 1.2.31 R;
(2) how it intends to deal with those risks; and
(3) details of the stress tests and scenario analyses carried out and the resulting financial resources estimated to be required in accordance with PRU 1.2.35 R.

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PRU 1.2.38

A firm must retain the records of its assessment of the adequacy of its financial resources for at least three years.

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PRU 1.2.39

Where a firm follows the guidance set out in PRU 2.3.35 G to PRU 2.3.48 G and assesses the adequacy of the capital resources requirement (CRR) in its particular circumstances as a basis for deciding what financial resources are adequate, it should include this in the documentation produced in accordance with PRU 1.2.37 R.

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Stress tests and scenario analyses

PRU 1.2.40

A large part of the process of managing a firm is based on an understanding of the expected outcomes of its business operations and outside events and the normal variation about these expected outcomes. To gain a comprehensive view of the risks being run by a firm, an analysis of extreme events is also needed. Such analysis may take the form of stress tests and scenario analyses. For example, a firm may normally expect interest rates to increase or decrease by 1 or 2 percentage points due to normal variations in economic conditions. However, in some extreme circumstances, interest rates may change by a much greater amount. The use of stress tests and scenario analyses can give a firm's management a better understanding of the firm's true exposure in extreme circumstances.

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PRU 1.2.41

Stress testing typically refers to shifting the values of individual parameters that affect the financial position of a firm and determining the effect on the firm's business.

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PRU 1.2.42

Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of catastrophic events on the firm's financial position, for example, simultaneous movements in a number of risk categories affecting all of a firm's business operations such as business volumes, investment values and interest rate movements.

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PRU 1.2.43

Scenarios generally could also be considered under three broad categories. For example, changes to the business plan, scenarios that involve changes in business cycles and those relating to extreme events. The scenarios can be derived in a variety of ways including stochastic models, analysis of historic experience or a repetition of an historical event. Scenarios can be developed with varying degrees of precision and depth.

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PRU 1.2.44

Both stress tests and scenario analyses can be undertaken by firms to further a better understanding of the vulnerabilities that they face under extreme conditions. They are based on the analysis of the impact of unlikely, but not impossible, events. These events can be financial, operational, legal or relate to any other risk that might have an economic impact on the firm.

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PRU 1.2.45

PRU 1.2.35 R requires a firm, as part of carrying out stress tests and scenario analyses, to take reasonable steps to identify an appropriate range of realistic circumstances and events in which a risk would crystallise. In particular:

(1) a firm need only carry out stress tests and scenario analyses in so far as the circumstances or events are reasonably foreseeable, that is to say, their occurrence is not too remote a possibility; and
(2) a firm should also take into account the relative costs and benefits of carrying out the stress tests and scenario analyses in respect of the circumstances and events identified.

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PRU 1.2.46

The purpose of stress tests and scenario analyses is to test the adequacy of overall financial resources. Scenarios need only be identified, and their impact assessed, in so far as this facilitates that purpose. In particular, the nature, depth and detail of the analysis depend, in part, upon the firm's capital strength and the robustness of its risk prevention and risk mitigation measures.

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PRU 1.2.47

Both stress testing and scenario analyses are prospective analysis techniques, which seek to anticipate possible losses that might occur if an identified risk crystallises. In applying them, a firm needs to decide how far forward to look. This should depend upon:

(1) how quickly it would be able to identify events or changes in circumstances that might lead to a risk crystallising resulting in a loss; and
(2) after it has identified the event or circumstance, how quickly and effectively it could act to prevent or mitigate any loss resulting from the risk crystallising and to reduce exposure to any further adverse event or change in circumstance.

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PRU 1.2.48

The time horizon over which stress tests and scenario analysis would need to be carried out for the market risk arising from the holding of investments, for example, should depend upon:

(1) the extent to which there is a regular, open and transparent market in those assets, which would allow fluctuations in the value of the investment to be more readily and quickly identified; and
(2) the extent to which the market in those assets is liquid (and would remain liquid in the changed circumstances contemplated in the stress test or scenario analysis) which would allow the firm, if needed, to sell its holding so as to prevent or reduce exposure to future price fluctuations.

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PRU 1.2.49

In identifying scenarios, and assessing their impact, a firm should take into account, where material, how changes in circumstances might impact upon:

(1) the nature, scale and mix of its future activities; and
(2) the behaviour of counterparties, and of the firm itself, including the exercise of choices (for example, options embedded in financial instruments or contracts of insurance).

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PRU 1.2.50

In determining whether it would have adequate financial resources in the event of each identified realistic adverse scenario, a firm should:

(1) only include financial resources that could reasonably be relied upon as being available in the circumstances of the identified scenario; and
(2) take account of any legal or other restriction on the purposes for which financial resources may be used.

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PRU 1.2.51

A firm should consider conducting stress tests and scenario analyses which enable it to assess its exposure not only in its current position in the economic and business cycles, but also the possible changes in the cycles which might be expected over, say, the next three to five years.

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PRU 1.2.52

A firm may consider scenarios in which expected future profits will provide capital reserves against future risks. However, it would only be appropriate to take into account profits that can be foreseen with some certainty as arising before the risk against which they are being held could possibly arise. In estimating future reserves, a firm should deduct future dividend payment estimates from projections of future profits.

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PRU 1.2.53

A firm may substitute for traditional stress tests and scenario analyses more sophisticated modelling techniques and this approach is acceptable providing major risks are identified and the modelling has the effect of calculating the effect on a firm's financial position where the risks crystallise or are assumed to crystallise with a particular probability.

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PRU 1.2.54

Additional guidance on stress tests and scenario analyses for the assessment of capital resources is available in PRU 2.3.

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PRU 1.2.55

Additional guidance in relation to stress tests and scenario analysis for liquidity risk is available in PRU 5.1.58 G to PRU 5.1.62 G.

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PRU 1.3

Valuation

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Application

PRU 1.3.1

PRU 1.3 applies to an insurer, unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 1.3.2

The scope of application of PRU 1.3 is not restricted to firms that are subject to relevant EC directives. It applies, for example, to pure reinsurers.

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PRU 1.3.3

(1) PRU 1.3 applies to a firm in relation to the whole of its business.
(2) Where a firm carries on both long-term insurance business and general insurance business, PRU 1.3 applies separately to each type of business.

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Purpose

PRU 1.3.4

PRU 1.3 sets out, for the purposes of PRU, rules and guidance as to how a firm should recognise and value assets, liabilities, equity and income statement items. Except where a rule in PRU makes different provision, PRU 1.3 applies whenever a rule in PRU refers to the value or amount of an asset, liability, equity or income statement item.

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General requirements: accounting principles to be applied

PRU 1.3.5

Subject to PRU 1.3.5A R and PRU 1.3.5B R, except where a rule in PRU provides for a different method of recognition or valuation, whenever a rule in PRU refers to an asset, liability, equity or income statement item, a firm must, for the purpose of that rule, recognise the asset, liability, equity or income statement item and measure its value in accordance with:

(1) the insurance accounts rules, or the Friendly Societies (Accounts and Related Provisions) Regulations 1994;
(2) Financial Reporting Standards and Statements of Standard Accounting Practice issued or adopted by the Accounting Standards Board; and
(3) Statements of Recommended Practice, issued by industry or sectoral bodies recognised for this purpose by the Accounting Standards Board; or
(4) international accounting standards;

as applicable to the firm for the purpose of its external financial reporting (or as would be applicable if the firm were a company with its head office in the United Kingdom).

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Past version of PRU 1.3.5 before 21/04/2005

PRU 1.3.5A

For the purposes of PRU, except where a rule in PRU provides for a different method of recognition or valuation, when a firm, upon initial recognition, designates its liabilities as at fair value through profit or loss, it must adjust any value calculated in accordance with PRU 1.3.5 R by subtracting any unrealised gains or adding back in any unrealised losses which are not attributable to changes in a benchmark interest rate.

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PRU 1.3.5B

For the purposes of PRU, except where a rule in PRU provides for a different method of recognition or valuation, in respect of a defined benefit occupational pension scheme:

(1) a firm must derecognise any defined benefit asset;
(2) a firm may substitute for a defined benefit liability the firm's deficit reduction amount.

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PRU 1.3.5C

An election made under PRU 1.3.5B R (2) must be applied consistently for the purposes of PRU in respect of any one financial year.

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PRU 1.3.5D

A firm should keep a record of and be ready to explain to its supervisory contacts in the FSA the reasons for any difference between the deficit reduction amount and any commitment the firm has made in any public document to provide funding in respect of a defined benefit occupational pension scheme.

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PRU 1.3.6

PRU 1.3.5 R provides that unless a rule in PRU provides for a different method of recognition or valuation, the applicable provisions of the Companies Act 1985, the Companies Act (Northern Ireland) Order 1986 or the Friendly Societies (Accounts and Related Provisions) Regulations 1994, as supplemented by Financial Reporting Standards, Statements of Standard Accounting Practice, and Statements of Recommended Accounting Practice, or, where applicable, international accounting standards, should be used to determine the recognition and valuation of assets, liabilities, equity and income statement items for the purposes of PRU, including:

(1) whether, and when, to recognise or de-recognise an asset or liability;
(2) the amount at which to value an asset, liability, equity or income statement item;
(3) which description to place on an asset, liability, equity or income statement item.

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Past version of PRU 1.3.6 before 21/04/2005

PRU 1.3.7

In particular, unless an exception applies, PRU 1.3.5 R should be applied for the purposes of PRU to determine how to account for:

(1) netting of amounts due to or from the firm;
(2) the securitisation of assets and liabilities (see also PRU 1.3.8 G);
(3) leased tangible assets;
(4) assets transferred or received under a sale and repurchase or stock lending transaction; and
(5) assets transferred or received by way of initial or variation margin under a derivative or similar transaction.

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PRU 1.3.8

Where assets or liabilities are securitised, PRU 1.3.5 R only permits de-recognition where Financial Reporting Standard 5 (or, where applicable, International Accounting Standard 39) permits either de-recognition or the linked presentation. However, the FSA will consider granting a waiver to permit de-recognition in other circumstances provided that the firm can demonstrate that securitisation has effectively transferred risk.

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Past version of PRU 1.3.8 before 21/04/2005

PRU 1.3.9

Specific provisions for the methods and assumptions to be used by a firm in calculating its mathematical reserves are made in PRU 7.3.

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PRU 1.3.10

PRU 1.3.5 R implements the requirements of Articles 23.3(viii) and 24.2(iv) of the Consolidated Life Directive. These articles require assets of a firm that are managed on its behalf by a subsidiary undertaking to be taken into account for the purposes of determining the firm's admissible assets and its assets in excess of concentration limits. The application of PRU 1.3.5 R will result in such assets remaining on the balance sheet of the firm.

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Investments, derivatives and quasi-derivatives

PRU 1.3.11

Subject to PRU 1.3.31 R, for the purposes of PRU, a firm must apply PRU 1.3.12 R to PRU 1.3.30 R in order to determine how to account for:

(1) investments that are, or amounts owed arising from the disposal of:

(a) debt securities, bonds and other money- and capital-market instruments; or
(b) loans; or
(c) shares and other variable yield participations; or
(d) units in UCITS schemes, non-UCITS retail schemes, recognised schemes and any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme); and

(2) derivatives and quasi-derivatives.

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Marking to market

PRU 1.3.12

Wherever possible, a firm must use mark to market in order to measure the value of the investments referred to in PRU 1.3.11 R. Marking to market is valuation at readily available close out prices from independent sources.

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PRU 1.3.13

For the purposes of PRU 1.3.12 R, examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

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PRU 1.3.14

When marking to market, a firm must use the more prudent side of bid/offer price unless the firm is a significant market maker in a particular position type and it can close out at the mid-market price.

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Marking to model

PRU 1.3.15

Where marking to market is not possible, a firm must use mark to model in order to measure the value of the investments referred to in PRU 1.3.11 R. Marking to model is any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input.

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PRU 1.3.16

When the model used is developed by the firm, that model must be:

(1) based on appropriate assumptions which have been assessed and challenged by suitably qualified parties independent of the development process; and
(2) independently tested, including validation of the mathematics, assumptions, and software implementation.

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PRU 1.3.17

A firm must ensure that its senior management are aware of the positions which are subject to mark to model and understand the materiality of the uncertainty this creates in the reporting of the performance of the business of the firm and the risks to which it is subject.

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PRU 1.3.18

A firm must source market inputs in line with market prices so far as possible and assess the appropriateness of the market inputs for the position being valued and the parameters of the model on each valuation date.

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PRU 1.3.19

A firm must use generally accepted valuation methodologies for particular products where these are available.

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PRU 1.3.20

A firm must establish formal change control procedures, hold a secure copy of the model, and periodically use that model to check valuations.

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PRU 1.3.21

A firm must ensure that its risk management functions are aware of the weakness of the models used and how best to reflect those in the valuation output.

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PRU 1.3.22

A firm must periodically review the model to determine the accuracy of its performance.

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PRU 1.3.23

Examples of periodical review are assessing the continued appropriateness of the assumptions and comparison of actual close out values to model inputs.

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Independent price verification

PRU 1.3.24

In addition to marking to market or marking to model, a firm must perform independent price verification. This is the process by which market prices or model inputs are regularly verified for accuracy and independence.

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PRU 1.3.25

For independent price verification, where independent pricing sources are not available or pricing sources are more subjective, for example, only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

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Valuation adjustments or reserves

PRU 1.3.26

A firm must establish and maintain procedures for considering valuation adjustments or reserves. These procedures must be compliant with the requirements set out in PRU 1.3.29 R.

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PRU 1.3.27

A firm using third-party valuations, or marking to model, must consider whether valuation adjustments are necessary.

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PRU 1.3.28

A firm must consider the need for establishing reserves for less liquid positions and, on an ongoing basis, review their continued appropriateness in accordance with the requirements set out in PRU 1.3.29 R.

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PRU 1.3.29

The requirements referred to in PRU 1.3.26 R and PRU 1.3.28 R are:

(1) a firm must consider the following adjustments or reserves: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, future administrative costs and, where appropriate, model risk; and
(2) a firm must consider several factors when determining whether a valuation reserve is necessary for less liquid items. These factors include the amount of time it would take to hedge out the position/risks within the position; the average and volatility of bid/offer spreads; the availability of market quotes (number and identity of market makers); and the average and volatility of trading volumes.

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Valuation adjustments or reserves

PRU 1.3.30

If the result of establishing adjustments or reserves under PRU 1.3.26 R to PRU 1.3.29 R is a valuation which differs from the fair value determined in accordance with PRU 1.3.5 R , a firm must reconcile the two valuations.

21/04/2005
Past version of PRU 1.3.30 before 21/04/2005

Shares in, and debts due from, related undertakings

PRU 1.3.31

PRU 1.3.11 R does not apply to shares in, and debts due from, a related undertaking that is:

(1) a regulated related undertaking; or
(2) an ancillary services undertaking; or
(3) any other subsidiary undertaking, the shares of which a firm elects to value in accordance with PRU 1.3.35 R.

31/12/2004

PRU 1.3.32

The effect of PRU 1.3.31 R is that shares in, and debts due from, related undertakings of the types referred to are not valued on a mark to market basis. As a result, debts due from these undertakings, and shares in related undertakings which are ancillary services undertakings, are valued at their accounting book value in accordance with PRU 1.3.5 R. Shares in related undertakings referred to in PRU 1.3.31 R (1) or (3) are valued in accordance with PRU 1.3.33 R to PRU 1.3.38 R.

31/12/2004

PRU 1.3.33

Except where the contrary is expressly stated in PRU, whenever a rule in PRU refers to shares held in, and debts due from, an undertaking referred to in PRU 1.3.31 R (1) or PRU 1.3.31R (3), a firm must value the shares held in accordance with PRU 1.3.35 R.

31/12/2004

PRU 1.3.34

In relation to shares in, and debts due from, an undertaking referred to in PRU 1.3.31 R (1), PRU 1.3.33 R does not apply for the purposes of PRU 2.2.78 R and PRU 8.3.

31/12/2004

PRU 1.3.35

For the purposes of PRU 1.3.33 R, the value of the shares held in an undertaking referred to in PRU 1.3.31 R (1) or PRU 1.3.31R (3) is the sum of:

(1) the regulatory surplus value of that undertaking; less
(2) for the purposes of PRU 2.2.90 R, the book value of the total investments in the tier one capital resources and tier two capital resources of that undertaking by the firm and its related undertakings; or
(3) for other purposes in PRU, the sum of:

(a) the book value of the investments by the firm and its related undertakings in the tier two capital resources of the undertaking; and
(b) if the undertaking is an insurance undertaking, its ineligible surplus capital and any restricted assets of the undertaking which have been excluded under PRU 8.3.41 R (1).

31/12/2004

PRU 1.3.36

For the purposes of PRU 1.3.35 R (1), the regulatory surplus value of an undertaking referred to in PRU 1.3.31 R (1) or PRU 1.3.31R (3) is, subject to PRU 1.3.37 R, the sum of:

(1) the tier one capital resources of the undertaking; plus
(2) the tier two capital resources of the undertaking; less
(3) the individual capital resources requirement of the undertaking.

31/12/2004

PRU 1.3.37

(1) Subject to PRU 1.3.38 R, for the purposes of PRU 1.3.36 R, only the relevant proportion of the:

(a) tier one capital resources of the undertaking;
(b) tier two capital resources of the undertaking;
(c) individual capital resources requirement of the undertaking;
is to be taken into account.

(2) In (1), the relevant proportion is the proportion of the total number of shares issued by the undertaking held, directly or indirectly, by the firm.

31/12/2004

PRU 1.3.38

If the individual capital resources requirement of an undertaking in PRU 1.3.31 R (1) that is a subsidiary undertaking exceeds the sum of its tier one capital resources and tier two capital resources, the full amount of the items referred to in PRU 1.3.37 R (1) are to be taken into account for the purposes of PRU 1.3.36 R.

31/12/2004

PRU 1.3.39

For the purposes of PRU 1.3.35 R to PRU 1.3.38 R:

(1) in relation to an undertaking referred to in PRU 1.3.31 R (1):

(a) individual capital resources requirement has the meaning given by PRU 8.3.34 R;
(b) the following expressions are to be construed in accordance with PRU 8.3.37 R:

(i) tier one capital resources; and
(ii) tier two capital resources;

(2) in relation to an undertaking referred to in PRU 1.3.31 R (3), the following expressions are to be construed as if that undertaking were an insurance holding company:

(a) individual capital resources requirement;
(b) tier one capital resources; and
(c) tier two capital resources.

31/12/2004

PRU 1.3.40

PRU 1.3.35 R to PRU 1.3.39 R set out several different valuation bases for a firm's shares in related undertakings. The regulatory surplus value (defined in PRU 1.3.36 R) measures the related undertaking's own capital surplus or deficit. This is used: (i) in PRU 1.3.35 R as a basis for calculating the impact on the firm's position of its investments in related undertakings; and (ii) in PRU 8.3 as a starting point for the calculation of ineligible surplus capital.

31/12/2004

PRU 1.3.41

PRU 1.3.35 R determines how, for the purposes of the solo capital adequacy calculation of a firm, that firm's capital resources should be adjusted to take into account its investments in related undertakings.

31/12/2004

PRU 1.3.42

The rules that specify how, for the purposes of the adjusted solo capital calculation, a firm must incorporate its related undertakings into its capital resources and capital resources requirement are set out in PRU 8.3.

31/12/2004

Community co-insurance operations: general insurance business

PRU 1.3.43

Where a relevant insurer determines the amount of a liability in order to make provision for outstanding claims under a Community co-insurance operation, then, if the leading insurer has informed the relevant insurer of the amount of the provision made by the leading insurer for such claims, the amount determined by the relevant insurer:

(1) must be at least as great as the amount of the provision made by the leading insurer; or
(2) in a case where it is not the practice in the United Kingdom to make such provision separately, must be sufficient, when all liabilities are taken into account, to include provision at least as great as that made by the leading insurer for such claims;

due regard being had in either case to the proportion of the risk covered by the relevant insurer and by the leading insurer respectively.

31/12/2004

PRU 1.4

Prudential risk management and associated systems and controls

31/12/2004

Application

PRU 1.4.1

PRU 1.4 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

31/12/2004

PRU 1.4.2

PRU 1.4 applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

only in respect of the activities of the firm carried on from a branch in the United Kingdom.

31/12/2004

Purpose

PRU 1.4.3

PRU 1.4 sets out some rules and guidance on the establishment and maintenance of systems and controls for the management of a firm's prudential risks. A firm's prudential risks are those that can reduce the adequacy of its financial resources, and as a result may adversely affect confidence in the financial system or prejudice consumers. Some key prudential risks are credit, market, liquidity, operational, insurance and group risk.

31/12/2004

PRU 1.4.4

The purpose of PRU 1.4 is to serve the FSA's regulatory objectives of consumer protection and market confidence. In particular, this section aims to reduce the risk that a firm may pose a threat to these regulatory objectives, either because it is not prudently managed, or because it has inadequate systems to permit appropriate senior management oversight and control of its business.

31/12/2004

PRU 1.4.5

Both adequate financial resources and adequate systems and controls are necessary for the effective management of prudential risks. A firm may hold financial resources to help alleviate the financial consequences of minor weaknesses in its systems and controls (to reflect possible impairments in the accuracy or timing of its identification, measurement, monitoring and control of certain risks, for example). However, financial resources cannot adequately compensate for significant weaknesses in a firm's systems and controls that could fundamentally undermine its ability to control its affairs effectively.

31/12/2004

How to interpret PRU 1.4

PRU 1.4.6

PRU 1.4 is designed to amplify Principle 3 (Management and control) which requires that a firm take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. PRU 1.4 is also designed to be complementary to SYSC 2, SYSC 3 and SYSC 3A in that it contains some additional rules and guidance on senior management arrangements and associated systems and controls for firms that could have a significant impact on the FSA's objectives in a prudential context.

31/12/2004

PRU 1.4.7

In addition to supporting PRIN and SYSC, PRU 1.4 lays the foundations for the more specific rules and guidance on the management of credit, market, liquidity, operational, insurance and group risks that are in PRU 3.1, PRU 4.1, PRU 5.1, PRU 6.1, PRU 7.1 and PRU 8.1 respectively. Many of the elements raised here in general terms are expanded upon in these sections.

31/12/2004

PRU 1.4.8

Appropriate systems and controls for the management of prudential risk will vary from firm to firm. Therefore most of the material in PRU 1.4 is guidance. In interpreting this guidance, a firm should have regard to its own particular circumstances. Following from SYSC 3.1.2 G, this should include considering the nature, scale and complexity of its business, which may be influenced by factors such as:

(1) the diversity of its operations, including geographical diversity;
(2) the volume and size of its transactions; and
(3) the degree of risk associated with each area of its operation.

31/12/2004

PRU 1.4.9

The guidance contained within this section is not designed to be exhaustive. When establishing and maintaining its systems and controls a firm should have regard not only to other parts of the Handbook, but also to material that is issued by other industry or regulatory bodies.

31/12/2004

The role of systems and controls in a prudential context

PRU 1.4.10

In a prudential context, a firm's systems and controls should provide its senior management with an adequate means of managing the firm. As such, they should be designed and maintained to ensure that senior management is able to make and implement integrated business planning and risk management decisions on the basis of accurate information about the risks that the firm faces and the financial resources that it has.

31/12/2004

The prudential responsibilities of senior management and the apportionment of those responsibilities

PRU 1.4.11

Ultimate responsibility for the management of prudential risks rests with a firm's governing body and relevant senior managers, and in particular with those individuals that undertake the firm's governing functions and the apportionment and oversight function. In particular, these responsibilities should include:

(1) overseeing the establishment of an appropriate business plan and risk management strategy;
(2) overseeing the development of appropriate systems for the management of prudential risks;
(3) establishing adequate internal controls; and
(4) ensuring that the firm maintains adequate financial resources.

31/12/2004

The delegation of responsibilities within the firm

PRU 1.4.12

Although authority for the management of a firm's prudential risks is likely to be delegated, to some degree, to individuals at all levels of the organisation, overall responsibility for this activity should not be delegated from its governing body and relevant senior managers.

31/12/2004

PRU 1.4.13

Where delegation does occur, a firm should ensure that appropriate systems and controls are in place to allow its governing body and relevant senior managers to participate in and control its prudential risk management activities. The governing body and relevant senior managers should approve and periodically review these systems and controls to ensure that delegated duties are being performed correctly.

31/12/2004

Firms subject to risk management on a group basis

PRU 1.4.14

Some firms organise the management of their prudential risks on a stand-alone basis. In some cases, however, the management of a firm's prudential risks may be entirely or largely subsumed within a whole group or sub-group basis.

(1) The latter arrangement may still comply with the FSA's prudential policy on systems and controls if the firm's governing body formally delegates the functions that are to be carried out in this way to the persons or bodies that are to carry them out. Before doing so, however, the firm's governing body should have explicitly considered the arrangement and decided that it is appropriate and that it enables the firm to meet the FSA's prudential policy on systems and controls. The firm should notify the FSA if the management of its prudential risks is to be carried out in this way.
(2) Where the management of a firm's prudential risks is largely, but not entirely, subsumed within a whole group or sub-group basis, the firm should ensure that any prudential issues that are specific to the firm are:

(a) identified and adequately covered by those to whom it has delegated certain prudential risk management tasks; or
(b) dealt with by the firm itself.

31/12/2004

PRU 1.4.15

Any delegation of the management of prudential risks to another part of a firm's group does not relieve it of responsibility for complying with the FSA's prudential policy on systems and controls. A firm cannot absolve itself of such a responsibility by claiming that any breach of the FSA's prudential policy on systems and controls is effected by the actions of a third party firm to whom the firm has delegated tasks. The risk management arrangements are still those of the firm, even though personnel elsewhere in the firm's group are carrying out these functions on its behalf. Thus any references in PRU to what a firm, its personnel and its management should and should not do still apply, and do not need any adjustment to cover the situation in which risk management functions are carried out on a group-wide basis.

31/12/2004

PRU 1.4.16

Where it is stated in PRU that a particular task in relation to a firm's systems and controls should be carried out by a firm's governing body this task should not be delegated to another part of its group. Furthermore, even where the management of a firm's prudential risks is delegated as described in PRU 1.4.14 G, responsibility for its effectiveness and for ensuring that it remains appropriate remains with the firm's governing body. The firm's governing body should therefore keep any delegation under review to ensure that delegated duties are being performed correctly.

31/12/2004

Business planning and risk management

PRU 1.4.17

Business planning and risk management are closely related activities. In particular, the forward-looking assessment of a firm's financial resources needs, and of how business plans may affect the risks that it faces, are important elements of prudential risk management. A firm's business planning should also involve the creation of specific risk policies which will normally outline a firm's strategy and objectives for, as appropriate, the management of its market, credit, liquidity, operational, insurance and group risks and the processes that it intends to adopt to achieve these objectives. PRU 1.4.18 R to PRU 1.4.25 G set out some rules and guidance relating to business planning and risk management in a prudential context (see also SYSC 3.2.17 G, which states that a firm should plan its business appropriately).

31/12/2004

PRU 1.4.18

A firm must take reasonable steps to ensure the establishment and maintenance of a business plan and appropriate systems for the management of prudential risk.

31/12/2004

PRU 1.4.19

When establishing and maintaining its business plan and prudential risk management systems, a firm must document:

(1) an explanation of its overall business strategy, including its business objectives;
(2) a description of, as applicable, its policies towards market, credit (including provisioning), liquidity, operational, insurance and group risk (that is, its risk policies), including its appetite or tolerance for these risks and how it identifies, measures or assesses, monitors and controls these risks;
(3) the systems and controls that it intends to use in order to ensure that its business plan and risk policies are implemented correctly;
(4) a description of how the firm accounts for assets and liabilities, including the circumstances under which items are netted, included or excluded from the firm's balance sheet and the methods and assumptions for valuation;
(5) appropriate financial projections and the results of its stress testing and scenario analysis (see PRU 1.2 Adequacy of financial resources); and
(6) details of, and the justification for, the methods and assumptions used in financial projections and stress testing and scenario analysis.

31/12/2004

PRU 1.4.20

The prudential risk management systems referred to in PRU 1.4.18 R and PRU 1.4.19 R are the means by which a firm is able to:

(1) identify the prudential risks that are inherent in its business plan, operating environment and objectives, and determine its appetite or tolerance for these risks;
(2) measure or assess its prudential risks;
(3) monitor its prudential risks; and
(4) control or mitigate its prudential risks.

PRU 5.1.78 E is an evidential provision relating to PRU 1.4.18 R concerning risk management systems in respect of liquidity risk arising from substantial exposures in foreign currencies.

31/12/2004

PRU 1.4.21

A firm should consider the relationship between its business plan, risk policies and the financial resources that it has available (or can readily access), recognising that decisions made in respect of one element may have consequences for the other two.

31/12/2004

PRU 1.4.22

A firm's business plan and risk management systems should be:

(1) effectively communicated so that all employees and contractors understand and adhere to the procedures related to their own responsibilities;
(2) regularly updated and revised, in particular when there is significant new information or when actual practice or performance differs materially from the documented strategy, policy or systems.

31/12/2004

PRU 1.4.23

The level of detail in a firm's business plan and its approach to the design of its risk management systems should be appropriate to the scale and complexity of its operations, and the nature and degree of risk that it faces.

31/12/2004

PRU 1.4.24

A firm's business plan and systems documentation should be accessible to the firm's management in line with their respective responsibilities and, upon request, to the FSA.

31/12/2004

PRU 1.4.25

PRU 1.4.19 R (5) requires a firm to document its financial projections and the results of its stress testing and scenario analysis. Such financial projections, stress tests and scenario analysis should be used by a firm's governing body and relevant senior managers when deciding upon how much risk the firm is willing to accept in pursuit of its business objectives and how risk limits should be set. Further rules and guidance on stress testing and scenario analysis are outlined in PRU 1.2 (Adequacy of financial resources) and PRU 5.1 (Liquidity risk systems and controls).

31/12/2004

Internal controls: introduction

PRU 1.4.26

Internal controls should provide a firm with reasonable assurance that it will not be hindered in achieving its objectives, or in the orderly and legitimate conduct of its business, by events that may reasonably be foreseen. More specifically in a prudential context, internal controls should be concerned with ensuring that a firm's business plan and risk management systems are operating as expected and are being implemented as intended. The following rule (PRU 1.4.27 R) reflects the importance of internal controls in a prudential context.

31/12/2004

PRU 1.4.27

A firm must take reasonable steps to establish and maintain adequate internal controls.

31/12/2004

PRU 1.4.28

The precise role and organisation of internal controls can vary from firm to firm. However, a firm's internal controls should normally be concerned with assisting its governing body and relevant senior managers to participate in ensuring that it meets the following objectives:

(1) safeguarding both the assets of the firm and its customers, as well as identifying and managing liabilities;
(2) maintaining the efficiency and effectiveness of its operations;
(3) ensuring the reliability and completeness of all accounting, financial and management information; and
(4) ensuring compliance with its internal policies and procedures as well as all applicable laws and regulations.

31/12/2004

PRU 1.4.29

When determining the adequacy of its internal controls, a firm should consider both the potential risks that might hinder the achievement of the objectives listed in PRU 1.4.28 G, and the extent to which it needs to control these risks. More specifically, this should normally include consideration of:

(1) the appropriateness of its reporting and communication lines (see SYSC 3.2.2 G);
(2) how the delegation or contracting of functions or activities to employees, appointed representatives or other third parties (for example outsourcing) is to be monitored and controlled (see SYSC 3.2.3 G to SYSC 3.2.4 G, PRU 1.4.12 G to PRU 1.4.16 G and PRU 1.4.33 G; additional guidance on the management of outsourcing arrangements is also provided in SYSC 3A.9);
(3) the risk that a firm's employees or contractors might accidentally or deliberately breach a firm's policies and procedures (see SYSC 3A.6.3 G);
(4) the need for adequate segregation of duties (see SYSC 3.2.5 G and PRU 1.4.30 G to PRU 1.4.33 G);
(5) the establishment and control of risk management committees (see PRU 1.4.34 G to PRU 1.4.37 G);
(6) the need for risk assessment and the establishment of a risk assessment function (see SYSC 3.2.10 G and PRU 1.4.38 G to PRU 1.4.41 G); and
(7) the need for internal audit and the establishment of an internal audit function and audit committee (see SYSC 3.2.15 G to SYSC 3.2.16 G and PRU 1.4.42 G to PRU 1.4.45 G).

31/12/2004

Internal controls: segregation of duties

PRU 1.4.30

The effective segregation of duties is an important internal control in the prudential context. In particular, it helps to ensure that no one individual is completely free to commit a firm's assets or incur liabilities on its behalf. Segregation can also help to ensure that a firm's governing body receives objective and accurate information on financial performance, the risks faced by the firm and the adequacy of its systems. In this regard, a firm should ensure that there is adequate segregation of duties between employees involved in:

(1) taking on or controlling risk (which could include risk mitigation);
(2) risk assessment (which includes the identification and analysis of risk); and
(3) internal audit.

31/12/2004

PRU 1.4.31

In addition, a firm should normally ensure that no single individual has unrestricted authority to do all of the following:

(1) initiate a transaction;
(2) bind the firm;
(3) make payments; and
(4) account for it.

31/12/2004

PRU 1.4.32

Where a firm is unable to ensure the complete segregation of duties (for example, because it has a limited number of staff), it should ensure that there are adequate compensating controls in place (for example, frequent review of an area by relevant senior managers).

31/12/2004

PRU 1.4.33

Where a firm outsources a controlled function, such as internal audit, it should take reasonable steps to ensure that every individual involved in the performance of this service is independent from the individuals who perform its external audit. This should not prevent services from being undertaken by a firm's external auditors provided that:

(1) the work is carried out under the supervision and management of the firm's own internal staff; and
(2) potential conflicts of interest between the provision of external audit services and the provision of controlled functions are properly managed.

31/12/2004

Internal controls: risk management committees

PRU 1.4.34

In many firms, especially if there are multiple business lines, it is common for the governing body to delegate some tasks related to risk control and management to committees such as asset and liability committees (ALCO), credit risk committees and market risk committees.

31/12/2004

PRU 1.4.35

Where a firm decides to create one or more risk management committee(s), adequate internal controls should be put in place to ensure that these committees are effective and that their actions are consistent with the objectives outlined in PRU 1.4.28 G. This should normally include consideration of the following:

(1) setting clear terms of reference, including membership, reporting lines and responsibilities of each committee;
(2) setting limits on their authority;
(3) agreeing routine reporting and non-routine escalation procedures;
(4) agreeing the minimum frequency of committee meetings; and
(5) reviewing the performance of these risk management committees.

31/12/2004

PRU 1.4.36

The decision to delegate risk management tasks, along with the terms of reference of the committees and their performance, should be reviewed periodically by the firm's governing body and revised as appropriate.

31/12/2004

PRU 1.4.37

The effective use of risk management committees can help to enhance a firm's internal controls. In establishing and maintaining its risk management committees, a firm should consider:

(1) their membership, which should normally include relevant senior managers (such as the head of group risk, head of legal, and the heads of market, credit, liquidity and operational risk, etc.), business line managers, risk management personnel and other appropriately skilled people, for example, actuaries, lawyers, accountants, IT specialists, etc.;
(2) using these committees to:

(i) inform the decisions made by a firm's governing body regarding its appetite or tolerance for risk taking;
(ii) highlight risk management issues that may require attention by the governing body;
(iii) consider risk at the firm-wide level and, within delegated limits, to determine the allocation of risk limits and financial resources across business lines;
(iv) consider how exposures may be unwound, hedged, or otherwise mitigated, as appropriate.

31/12/2004

Internal controls: risk assessment

PRU 1.4.38

Risk assessment is the process through which a firm identifies and analyses (using both qualitative and quantitative methodologies) the risks that it faces. A firm's risk assessment activities should normally include consideration of:

(1) its total exposure to risk at the firm-wide level (that is, its exposure across business lines and risk categories);
(2) capital allocation and the need to calculate risk weighted returns for different business lines;
(3) the potential correlations that can exist between the risks in different business lines; this should also include looking for risks to which a firm's business plan is particularly sensitive, such as interest rate risk, or multiple dealings with the same counterparty;
(4) the use of stress tests and scenario analysis;
(5) whether there are risks inherent in the firm's business that are not being addressed adequately;
(6) the risk adjusted return that the firm is achieving; and
(7) the adequacy and timeliness of management information on market, credit, insurance, liquidity, operational and group risks from the business lines, including risk limit utilisation.

31/12/2004

PRU 1.4.39

In accordance with SYSC 3.2.10 G a firm should consider whether it needs to set up a separate risk assessment function (or functions) that is responsible for assessing the risks that the firm faces and advising its governing body and senior managers on them.

31/12/2004

PRU 1.4.40

Where a firm does decide that it needs a separate risk assessment function, the employees or contractors that carry out this function should not normally be involved in risk taking activities such as business line management (see PRU 1.4.30 G to PRU 1.4.33 G on the segregation of duties).

31/12/2004

PRU 1.4.41

A summary of the results of the analysis undertaken by a firm's risk assessment function (including, where necessary, an explanation of any assumptions that were adopted) should normally be reported to relevant senior managers as well as to the firm's governing body.

31/12/2004

Internal audit

PRU 1.4.42

A firm should ensure that it has appropriate mechanisms in place to assess and monitor the appropriateness and effectiveness of its systems and controls. This should normally include consideration of:

(1) adherence to and effectiveness of, as appropriate, its market, credit, liquidity, operational, insurance, and group risk policies;
(2) whether departures and variances from its documented systems and controls and risk policies have been adequately documented and appropriately reported, including whether appropriate pre-clearance authorisation has been sought for material departures and variances;
(3) adherence to and effectiveness of its accounting policies, and whether accounting records are complete and accurate;
(4) adherence to and effectiveness of its management reporting arrangements, including the timeliness of reporting, and whether information is comprehensive and accurate; and
(5) adherence to FSA rules and regulatory prudential standards.

31/12/2004

PRU 1.4.43

In accordance with SYSC 3.2.15 G and SYSC 3.2.16 G, a firm should consider whether it needs to set up a dedicated internal audit function.

31/12/2004

PRU 1.4.44

Where a firm decides to set up an internal audit function, this function should provide independent assurance to its governing body, audit committee or an appropriate senior manager of the integrity and effectiveness of its systems and controls.

31/12/2004

PRU 1.4.45

In forming its judgements, the person performing the internal audit function should test the practical operation of a firm's systems and controls as well as its accounting and risk policies. This should include examining the adequacy of supporting records.

31/12/2004

Management information

PRU 1.4.46

Many individuals, at various levels of a firm, need management information relating to their activities. However, PRU 1.4.47 G to PRU 1.4.50 G concentrates on the management information that should be available to those at the highest level of a firm, that is, the firm's governing body and relevant senior managers. In so doing PRU 1.4.47 G to PRU 1.4.50 G amplifies SYSC 3.2.11 G to SYSC 3.2.12 G (which outlines the FSA's high level policy on senior management information) by providing some additional guidance on the management information that should be available in a prudential context.

31/12/2004

PRU 1.4.47

The role of management information should be to help a firm's governing body and senior managers to understand risk at a firm-wide level. In so doing, it should help them to:

(1) determine whether a firm is prudently managed with adequate financial resources;
(2) make the decisions that fall within their ambit (for example, the high level business plans, strategy and risk tolerances of the firm); and
(3) oversee the execution of tasks for which they are responsible.

31/12/2004

PRU 1.4.48

A firm should consider what information needs to be made available to its governing body and senior managers. Some possible examples include:

(1) firm-wide information such as the overall profitability and value of a firm and its total exposure to risk;
(2) reports from committees to which the governing body has delegated risk management tasks, if applicable;
(3) reports from a firm's internal audit and risk assessment functions, if applicable, including exception reports, where risk limits and policies have been breached or systems circumvented;
(4) financial projections under expected and abnormal (that is, stressed) conditions;
(5) reconciliation of actual profit and loss to previous financial projections and an analysis of any significant variances;
(6) matters which require a decision from the governing body or senior managers, for example a significant variation to a business plan, amendments to risk limits, the creation of a new business line, etc;
(7) compliance with FSA rules and regulatory prudential standards;
(8) risk weighted returns; and
(9) liquidity and funding requirements.

31/12/2004

PRU 1.4.49

The management information that is provided to a firm's governing body and senior managers should have the following characteristics:

(1) it should be timely, its frequency being determined by factors such as:

(a) the volatility of the business in which the firm is engaged (that is, the speed at which its risks can change);
(b) any time constraints on when action needs to be taken; and
(c) the level of risk that the firm is exposed to, compared to its available financial resources and tolerance for risk;

(2) it should be reliable, having regard to the fact that it may be necessary to sacrifice a degree of accuracy for timeliness; and
(3) it should be presented in a manner that highlights any relevant issues on which those undertaking governing functions should focus particular attention.

31/12/2004

PRU 1.4.50

The production of management and other information may require the collation of data from a variety of separate manual and automated systems. In such cases, responsibility for the integrity of the information may be spread amongst a number of operational areas. A firm should ensure that it has appropriate processes to validate the integrity of its information.

31/12/2004

Record keeping

PRU 1.4.51

SYSC 3.2.20 R requires a firm to take reasonable care to make and retain adequate records. The following policy on record keeping supplements SYSC 3.2.20 R by providing some additional rules and guidance on record keeping in a prudential context. The purpose of this policy is to:

(1) facilitate the prudential supervision of a firm by ensuring that adequate information is available regarding its past/current financial situation and business activities (which includes the design and implementation of systems and controls); and
(2) help the FSA to satisfy itself that a firm is operating in a prudent manner and is not prejudicing the interests of its customers or market confidence.

31/12/2004

PRU 1.4.52

In addition to the record keeping requirements in PRU, a firm should remember that it may be obliged, under other applicable laws or regulations, to keep similar or additional records.

31/12/2004

PRU 1.4.53

(1) A firm must make and regularly update accounting and other records that are sufficient to enable the firm to demonstrate to the FSA:

(a) that the firm is financially sound and has appropriate systems and controls;
(b) the firm's financial position and exposure to risk (to a reasonable degree of accuracy); and
(c) the firm's compliance with the rules in PRU.

(2) The records in (1) must be retained for a minimum of three years, or longer as appropriate.

31/12/2004

PRU 1.4.54

A firm should be able to make available the records described in PRU 1.4.53 R within a reasonable timeframe when requested to do so by the FSA.

31/12/2004

PRU 1.4.55

The FSA recognises that not all records are specific to a particular point in time. As such, while it may be appropriate to update some records on a daily or continuous basis, for example expenditure and details of certain transactions, it may not be appropriate to update other records as regularly as this, for example those relating to its business plan and risk policies. A firm should decide how regularly it should update particular records.

31/12/2004

PRU 1.4.56

A firm should decide which records it needs to hold, noting that compliance with PRU 1.4.53 R does not require it to hold records on every single aspect of its activities. Some specific guidance on the types of records that a firm should hold is set out in each of the risk specific sections on systems and controls (see PRU 3.1, PRU 4.1, PRU 5.1, PRU 6.1, PRU 7.1 and PRU 8.1).

31/12/2004

PRU 1.4.57

In deciding which records to hold, a firm should also take into account that failure to keep adequate records could make it harder for it to satisfy the FSA that it is compliant with the rules in PRU, and to defend any enforcement action taken against it.

31/12/2004

PRU 1.4.58

A firm should keep the records required in PRU in an appropriate format and language (in terms of format this could include holding them on paper or in electronic or some other form). However, whatever format or language a firm chooses, SYSC 3.2.20 R requires that records be capable of being reproduced on paper and in English (except where they relate to business carried on from an establishment situated in a country where English is not an official language).

31/12/2004

PRU 1.4.59

In accordance with SYSC 3.2.20 R, a firm should retain the records that it needs to comply with PRU 1.4.53 R for as long as they are relevant for the purposes for which they were made.

31/12/2004

PRU 1.4.60

A firm must keep the records required in PRU 1.4.53 R in the United Kingdom, except where:

(1) they relate to business carried on from an establishment in a country or territory that is outside the United Kingdom; and
(2) they are kept in that country or territory.

31/12/2004

PRU 1.4.61

When a firm keeps the records required in PRU 1.4.53 R outside the United Kingdom, it must periodically send an adequate summary of those records to the United Kingdom.

31/12/2004

PRU 1.4.62

Where a firm outsources the storage of some or all of its records to a third party service provider, it should ensure that these records are readily accessible and can be reproduced within a reasonable time period. The firm should also ensure that these records are stored in compliance with the rules and guidance on record keeping in PRU. Additional guidance on the management of outsourcing agreements is provided in SYSC 3A.

31/12/2004

PRU 1.4.63

A firm may rely on records that have been produced by a third party (for example, another group company or an external agent, such as an outsource service provider). However where the firm does so it should ensure that these records are readily accessible and can be reproduced within a reasonable time period. The firm should also ensure that these records comply with the rules and guidance on record keeping in PRU.

31/12/2004

PRU 1.4.64

In accordance with SYSC 3.2.21 G, a firm should have adequate systems and controls for maintaining the security of its records so that they are reasonably safeguarded against loss, unauthorised access, alteration or destruction.

31/12/2004

PRU 1.5

to follow

31/12/2004

to follow

PRU 1.6

to follow

31/12/2004

to follow

PRU 1.7

to follow

31/12/2004

to follow

PRU 1.8

Actions for damages

31/12/2004

PRU 1.8.1

A contravention of the rules in PRU does not give rise to a right of action by a private person under section 150 of the Act (and each of those rules is specified under section 150(2) of the Act as a provision giving rise to no such right of action).

11/08/2004

Export chapter as

Legal Instruments that change this Chapter Application and general requirements

PRU 2

Capital

PRU 2.1

Calculation of capital resources requirements

31/12/2004

Application

PRU 2.1.1

PRU 2.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

PRU 2.1.2

The scope of application of PRU 2.1 is not restricted to firms that are subject to the relevant EC Directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 2.1.3

(1) PRU 2.1 applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.
(2) Where a firm carries on both long-term insurance business and general insurance business, PRU 2.1 applies separately to each type of business.

31/12/2004

PRU 2.1.4

The adequacy of a firm's capital resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

31/12/2004

PRU 2.1.5

The requirements in PRU 2.1 apply to a firm on a solo basis.

31/12/2004

Purpose

PRU 2.1.6

31/12/2004

PRU 2.1.7

This section (PRU 2.1) sets capital resources requirements for a firm. PRU 2.2 sets out how, for the purpose of this, the amounts or values of capital, assets and liabilities are to be determined. More detailed rules relating to capital, assets and liabilities are also set out in the following chapters and sections:

(1) PRU 1.3 Valuation;
(2) PRU 3 Credit risk;
(3) PRU 4 Market risk;
(4) PRU 5 Liquidity risk;
(5) PRU 6 Operational risk;
(6) PRU 7 Insurance risk; and
(7) PRU 8 Group risk.

PRU 2.1 and PRU 2.2 include appropriate cross-references to these chapters and sections.

31/12/2004

PRU 2.1.8

PRU 2.1 implements minimum EC standards for the capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

31/12/2004

Main requirements

PRU 2.1.9

(1) A firm must maintain at all times capital resources equal to or in excess of its capital resources requirement (CRR).
(2) A firm which is a participating insurance undertaking and, in relation to its own group capital resources, is in compliance with PRU 8.3.9 R, is deemed to comply with (1).

31/12/2004

PRU 2.1.10

A firm must comply with PRU 2.1.9 R separately in respect of both its long-term insurance business and its general insurance business.

31/12/2004

PRU 2.1.11

In order to comply with PRU 2.1.10 R, a firm carrying on both general insurance business and long-term insurance business will need to allocate its capital resources between its general insurance business and long-term insurance business so that the capital resources allocated to its general insurance business are equal to or in excess of its CRR for its general insurance business and the capital resources allocated to its long-term insurance business are equal to or in excess of its CRR for its long-term insurance business. Whereas long-term insurance assets cannot be used towards meeting a firm's CRR for its general insurance business, surplus general insurance assets may be used towards meeting the CRR for its long-term insurance business (see PRU 7.6.30 R to PRU 7.6.32 G). PRU 7.6 sets out the detailed requirements for the separation of long-term and general insurance business.

31/12/2004

PRU 2.1.12

Firms commonly use different terminology for the various PRU requirements. For example, the MCR is traditionally known as the required minimum margin.

31/12/2004

PRU 2.1.13

The FSA may impose a higher capital requirement than the minimum requirement set out in this section as part of the firm's Part IV permission. (See PRU 2.3).

31/12/2004

Calculation of the CRR

PRU 2.1.14

The CRR for any firm carrying on general insurance business is equal to the MCR in PRU 2.1.21 R.

31/12/2004

PRU 2.1.15

The CRR for any firm to which this rule applies (see PRU 2.1.16 R and PRU 2.1.17 R) is the higher of:

(1) the MCR in PRU 2.1.22 R; and
(2) the ECR in PRU 2.1.34 R.

31/12/2004

PRU 2.1.16

Subject to PRU 2.1.17 R, PRU 2.1.15 R applies to a firm carrying on long-term insurance business, other than:

(1) a non-directive mutual;
(2) a firm which has no with-profits insurance liabilities; and
(3) a firm which has with-profits insurance liabilities that are, and at all times since 31 December 2004 (the coming into force of PRU 2.1.15 R) have remained, less than £500 million.

31/12/2004

PRU 2.1.17

PRU 2.1.15 R also applies to a firm of a type listed in PRU 2.1.16 R (3) if:

(1) the firm makes an election that PRU 2.1.15 R is to apply to it; and
(2) that election is made by written notice given to the FSA in a way that complies with the requirements for written notice in SUP 15.7.

31/12/2004

PRU 2.1.18

The effect of PRU 2.1.16 R (3) is that a firm to which PRU 2.1.15 R applies because it has with-profits insurance liabilities of £500 million or more, will continue to be subject to PRU 2.1.15 R even if its with-profits insurance liabilities fall below £500 million. However, if that happens, it may apply for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to the prospects of it continuing to have with-profits insurance liabilities of less than £500 million.

31/12/2004

PRU 2.1.19

A firm that has always had with-profits insurance liabilities of less than £500 million since PRU 2.1.15 R came into force may wish to "opt in" to PRU 2.1.15 R and therefore become a realistic basis life firm. By doing so, it becomes obliged to calculate a with-profits insurance capital component (see PRU 2.1.34 R and PRU 7.4), but it also becomes entitled to certain modifications to the way that a firm is required to calculate its mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R). The firm is also then required to report its liabilities on a realistic basis (see IPRU(INS) rule 9.31R(b)). In order to "opt in", the firm must make an election under PRU 2.1.17 R that PRU 2.1.15 R is to apply to it. If a firm that has elected to calculate and report its with-profits insurance liabilities on a realistic basis subsequently decides that it no longer wishes to do so, it may seek to "opt out" by applying for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to whether it continues to have with-profits insurance liabilities of less than £500 million.

31/12/2004

PRU 2.1.20

The CRR for a firm carrying on long-term insurance business, but to which PRU 2.1.15 R does not apply, is equal to the MCR in PRU 2.1.22 R.

31/12/2004

Calculation of the MCR

PRU 2.1.21

For a firm carrying on general insurance business, the MCR in respect of that business is the higher of:

(1) the base capital resources requirement for general insurance business applicable to that firm; and
(2) the general insurance capital requirement.

31/12/2004

PRU 2.1.22

For a firm carrying on long-term insurance business, the MCR in respect of that business is the higher of:

(1) the base capital resources requirement for long-term insurance business applicable to that firm; and
(2) the sum of:

(a) the long-term insurance capital requirement; and
(b) the resilience capital requirement.

31/12/2004

PRU 2.1.23

The MCR gives effect to the EC Directive minimum requirements. For general insurance business, the EC Directive minimum is the higher of the general insurance capital requirement and the relevant base capital resources requirement. For long-term insurance business, the EC Directive minimum is the higher of the long-term insurance capital requirement and the base capital resources requirement. The base capital resources requirement is the minimum guarantee fund for the purposes of article 29(2) of the Consolidated Life Directive (2002/83/EC) and article 17(2) of the First Non-Life Directive (73/239/EEC) as amended. The resilience capital requirement is an FSA requirement that is additional to the EC minimum requirement for long-term insurance business.

31/12/2004

PRU 2.1.24

The calculation of the resilience capital requirement is set out in PRU 4.2.

31/12/2004

Calculation of the base capital resources requirement

PRU 2.1.25

The amount of a firm's base capital resources requirement is set out in Table 2.1.26R.

31/12/2004

PRU 2.1.26

Table: Base capital resources requirement

Firm type

Amount: Currency equivalent of

General insurance business

Liability insurer
(classes 10-15)

Directive mutual

€2.25 million

Non-directive insurer

€300,000

Overseas firm

€1.5 million

Other

€3 million

Other insurer

Directive mutual

€1.5 million

Non-directive insurer
(classes 1 to 8, 16 or 18)

€225,000

Non-directive insurer
(classes 9 or 17)

€150,000

Overseas firm

€1 million

Other

€2 million

Long-term insurance business

Mutual

Directive

€2.25 million

Non-directive

€600,000

Overseas firm

€1.5 million

Any other insurer

€3 million

31/12/2004

PRU 2.1.27

(1) Subject to (2) and (3), the amount of the base capital resources requirement specified in the last column of the table in PRU 2.1.26 R for a firm which is not a non-directive insurer will increase each year, starting on the review date of 20 September 2005 (and annually after that), by the percentage change in the European index of consumer prices (comprising all EU member states, as published by Eurostat) from 20 March 2002, to the relevant review date, rounded up to a multiple of €100,000.
(2) In any year, if the percentage change since the last increase is less than 5%, then there will be no increase.
(3) The increase will take effect 30 days after the EU Commission has informed the European Parliament and Council of its review and the relevant percentage change.

31/12/2004

PRU 2.1.28

Any increases in the base capital resources requirement referred to in PRU 2.1.27 R will be published on the FSA website.

31/12/2004

PRU 2.1.29

For the purposes of the base capital resources requirement, the exchange rate from the Euro to the pound sterling for each year beginning on 31 December is the rate applicable on the last day of the preceding October for which the exchange rates for the currencies of all the European Union member states were published in the Official Journal of the European Union.

31/12/2004

Calculation of the general insurance capital requirement

PRU 2.1.30

A firm must calculate its general insurance capital requirement as the highest of:

(1) the premiums amount;
(2) the claims amount; and
(3) the brought forward amount.

31/12/2004

PRU 2.1.31

The calculation of each of the premiums amount, claims amount and brought forward amount is set out in PRU 7.2.

31/12/2004

Calculation of the long-term insurance capital requirement

PRU 2.1.32

A firm must calculate its long-term insurance capital requirement as the sum of:

(1) the insurance death risk capital component;
(2) the insurance health risk capital component;
(3) the insurance expense risk capital component; and
(4) the insurance market risk capital component.

31/12/2004

PRU 2.1.33

The calculation of each of the capital components is set out in PRU 7.2.

31/12/2004

Calculation of the ECR

PRU 2.1.34

For a firm carrying on long-term insurance business, the ECR in respect of that business is the sum of:

(1) the long-term insurance capital requirement;
(2) the resilience capital requirement; and
(3) the with-profits insurance capital component.

31/12/2004

PRU 2.1.35

Details of the resilience capital requirement and the with-profits insurance capital component are set out in PRU 4.2 and PRU 7.4 respectively.

31/12/2004

Monitoring requirements

PRU 2.1.36

A firm must at all times monitor whether it is complying with PRU 2.1.9 R and be able to demonstrate that it knows at all times whether it is complying with that rule.

31/12/2004

PRU 2.1.37

For the purposes of PRU 2.1.36 R, a firm should have systems in place to enable it to be certain whether it has adequate capital resources to comply with PRU 2.1.9 R at all times. This does not necessarily mean that a firm needs to measure the precise amount of its capital resources and its CRR on a daily basis. A firm should, however, be able to demonstrate the adequacy of its capital resources at any particular time if asked to do so by the FSA.

31/12/2004

PRU 2.1.38

A firm must notify the FSA immediately of any breach, or expected breach, of PRU 2.1.9 R.

31/12/2004

PRU 2.2

Capital resources

31/12/2004

Application

PRU 2.2.1

PRU 2.2 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

Purpose

PRU 2.2.2

PRU 2.1 sets out minimum capital resources requirements for a firm. This section (PRU 2.2) sets out how, for the purpose of these requirements, capital resources are defined and measured. PRU 2.2 also implements minimum EC standards for the composition of capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

31/10/2004

Principles underlying the definition of capital resources

PRU 2.2.3

The FSA has divided its definition of capital into categories, or tiers, reflecting differences in the extent to which the capital instruments concerned meet the purpose and conform to the characteristics of capital listed in PRU 2.2.5 G. The FSA generally prefers a firm to hold higher quality capital that meets the characteristics of permanency and loss absorbency that are features of tier one capital. Capital instruments falling into core tier one capital can be included in a firm's regulatory capital without limit. Typically, other forms of capital are either subject to limits (see PRU 2.2.16 R to PRU 2.2.26 R) or, in the case of some specialist types of capital, may only be included with the express consent of the FSA (which takes the form of a waiver under section 148 of the Act).

31/10/2004

PRU 2.2.4

Details of the individual components of capital are set out in PRU 2.2.14 R.

31/10/2004

Tier one capital

PRU 2.2.5

Tier one capital typically has the following characteristics:

(1) it is able to absorb losses;
(2) it is permanent;
(3) it ranks for repayment upon winding up after all other debts and liabilities; and
(4) it has no fixed costs, that is, there is no inescapable obligation to pay dividends or interest.

31/10/2004

PRU 2.2.6

The forms of capital that qualify for tier one capital are set out in PRU 2.2.14 R and include, for example, share capital, reserves, verified interim net profits and, for a mutual, the initial fund plus permanent members' accounts. Tier one capital is divided into core tier one capital, perpetual non-cumulative preference shares, and innovative tier one capital.

31/10/2004

Upper and lower tier two capital

PRU 2.2.7

Tier two capital includes forms of capital that do not meet the requirements for permanency and absence of fixed servicing costs that apply to tier one capital. Tier two capital includes, for example:

(1) capital which is perpetual (that is, has no fixed term) but cumulative (that is, servicing costs cannot be waived at the issuer's option, although they may be deferred - for example cumulative preference shares); perpetual capital instruments may be included in upper tier two capital; and
(2) capital which is not perpetual (that is, it has a fixed term) and which may also have fixed servicing costs that cannot generally be either waived or deferred, for example subordinated debt. Such capital should normally be of a medium to long-term maturity (that is, an original maturity of at least five years). Dated capital instruments are included in lower tier two capital.

31/12/2004
Past version of PRU 2.2.7 before 31/12/2004

Deductions from capital

PRU 2.2.8

Deductions should be made at the relevant stage of the calculation of capital resources to reflect capital that may not be available to the firm or assets of uncertain value, for example, holdings of intangible assets and assets that are inadmissible for a firm.

31/10/2004

PRU 2.2.9

A full list of deductions from capital resources is shown in PRU 2.2.14 R.

31/12/2004

Calculation of capital resources

PRU 2.2.10

Capital resources can be calculated either as the total of eligible assets less foreseeable liabilities (which is the approach taken in the Insurance Directives) or by identifying the components of capital. Both calculations give the same result for the total amount of capital resources. The approach taken in this section has been to specify the components of capital and the relevant deductions. This is set out in PRU 2.2.14 R. This approach is the same as that used for the calculation of capital resources for banks, building societies and investment firms. A simple example, showing the reconciliation of the two methods, is given in PRU 2.2.11 G.

31/10/2004

PRU 2.2.11

Table: Approaches to calculating capital resources

Liabilities

Assets

Borrowings

100

Admissible assets

350

Ordinary shares

200

Intangible assets

100

Profit and loss account and other reserves

100

Other inadmissible assets

100

Perpetual subordinated debt

150

Total

550

Total

550

Calculation of capital resources: eligible assets less foreseeable liabilities

Total assets

550

less intangible assets

(100)

less inadmissible assets

(100)

less liabilities (borrowings)

(100)

Capital resources

250

Calculation of capital resources: components of capital

Ordinary shares

200

Profit and loss account and other reserves

100

Perpetual subordinated debt

150

less intangible assets

(100)

less inadmissible assets

(100)

Capital resources

250

31/10/2004

PRU 2.2.12

A firm must calculate its capital resources for the purpose of PRU in accordance with PRU 2.2.14 R, subject to the limits in PRU 2.2.16 R to PRU 2.2.26 R.

31/10/2004

PRU 2.2.13

Where PRU 2.2.14 R refers to related text, it is necessary to refer to that text in order to understand fully what is included in the descriptions of capital items and deductions set out in the table.

31/10/2004

PRU 2.2.14

Table: Capital resources (see PRU 2.2.12 R )

Related text

Included in the calculation of capital resources

A √ denotes that the item is included in the calculation of a firm's capital resources: a x denotes that the item is not included in the calculation of a firm's capital resources.

(A) Core tier one capital:

Permanent share capital

PRU 2.2.36 R

√

Profit and loss account and other reserves

PRU 2.2.76 R and PRU 2.2.77 R

√

Share premium account

None

√

Externally verified interim net profits

PRU 2.2.82 R

√

Positive valuation differences

PRU 2.2.78 R

√

Fund for future appropriations

None

√

(B) Perpetual non-cumulative preference shares

Perpetual non-cumulative preference shares

PRU 2.2.50 R

√

Innovative tier one instruments

PRU 2.2.52 R to PRU 2.2.75 R

√

(D) Total tier one capital before deductions = A + B + C

(E) Deductions from tier one capital:

Investments in own shares

None

√

Intangible assets

PRU 2.2.84 R

√

Amounts deducted from technical provisions for discounting and other negative valuation differences

PRU 2.2.78 R to PRU 2.2.81 R

√

(F) Total tier one capital after deductions = D - E

(G) Upper tier two capital:

Perpetual cumulative preference shares

PRU 2.2.101 R

√

Perpetual subordinated debt

PRU 2.2.101 R

√

Perpetual subordinated securities

PRU 2.2.101 R

√

(H) Lower tier two capital

Fixed term preference shares

PRU 2.2.108 R

√

Fixed term subordinated debt

PRU 2.2.108 R

√

Fixed term subordinated securities

PRU 2.2.108 R

√

(I) Total tier two capital = G + H

(J) Positive adjustments for related undertakings

Related undertakings that are regulated related undertakings (other than insurance undertakings)

PRU 2.2.90 R

√

(K) Total capital after positive adjustments for regulated related undertakings that are not insurance undertakings but before deductions = F + I + J

(L) Deductions from total capital

Inadmissible assets

PRU 2.2.86 R & PRU 2 Annex 1R

√

Assets in excess of market risk and counterparty limits

PRU 3.2.22 R

√

PRU 2.2.89 R

√

Negative adjustments for related undertakings that are regulated related undertakings (other than insurance undertakings)

PRU 2.2.90 R

√

(M) Total capital after deductions = K - L

(N) Other capital resources*:

Unpaid share capital or, in the case of a mutual, unpaid initial funds and calls for supplementary contributions

PRU 2.2.126 G to PRU 2.2.128 G

Implicit items

PRU 2 Annex 2 G

(O) Total capital resources after deductions = M + N

* Items in section (N) of the table can be included in capital resources if subject to a waiver under section 148 of the Act.

31/10/2004

Limits on the use of different forms of capital

PRU 2.2.15

As the various components of capital differ in the degree of protection that they offer the firm and its customers, restrictions are placed on the extent to which certain types of capital are eligible for inclusion in a firm's capital resources. These restrictions are set out in PRU 2.2.16 R to PRU 2.2.26 R.

31/10/2004

PRU 2.2.16

At least 50% of a firm's MCR must be accounted for by the sum of:

(1) the amount calculated at stage A of the calculation in PRU 2.2.14 R; and
(2) notwithstanding PRU 2.2.20 R (1), the amount calculated at stage B of the calculation in PRU 2.2.14 R;

less the amount calculated at stage E of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.17

A firm carrying on long-term insurance business must meet the higher of:

(1) 1/3 of the long-term insurance capital requirement; and
(2) the base capital resources requirement;

with the sum of the items listed at stages A, B, G and H less the sum of the items listed at stage E in PRU 2.2.14 R.

31/10/2004

PRU 2.2.18

A firm carrying on general insurance business must meet the higher of:

(1) 1/3 of the general insurance capital requirement; and
(2) the base capital resources requirement;

with the sum of the items listed at stages A, B, G and H less the sum of the items listed at stage E in PRU 2.2.14 R.

31/10/2004

PRU 2.2.19

The purposes of the requirements in PRU 2.2.16 R to PRU 2.2.18 R are to comply with the Insurance Directives' requirement that firms maintain a guarantee fund of higher quality capital resources items and to ensure that at least 50% of the firm's capital resources needed to meet its MCR provide maximum loss absorbency to protect the firm from insolvency.

31/10/2004

PRU 2.2.20

In relation to a firm's tier one capital resources calculated at stage F of the calculation in PRU 2.2.14 R:

(1) at least 50% must be accounted for by core tier one capital; and
(2) no more than 15% may be accounted for by innovative tier one capital.

31/10/2004

PRU 2.2.21

The purpose of the requirement in PRU 2.2.20 R (1) is to ensure that at least 50% of the firm's tier one capital resources (net of tier one capital deductions) is met by core tier one capital which provides maximum loss absorbency on a going concern basis to protect the firm from insolvency. Although a perpetual non-cumulative preference share is in legal form a share, it behaves in many ways like a perpetual fixed interest debt instrument. Within the 50% limit on non-core tier one capital, PRU 2.2.20 R (2) places a further sub-limit on the amount of innovative tier one capital that a firm may include in its tier one capital resources. This limit is necessary to ensure that most of a firm's tier one capital comprises items of capital of the highest quality.

31/10/2004

PRU 2.2.22

The amount of any capital item excluded from a firm's tier one capital resources under PRU 2.2.20 R may form part of its tier two capital resources subject to the limits in PRU 2.2.23 R.

31/10/2004

PRU 2.2.23

Subject to PRU 2.2.24 R, a firm must exclude from the calculation of its capital resources the following:

(1) the amount (if any) by which tier two capital resources exceed the amount calculated at stage F of the calculation in PRU 2.2.14 R; and
(2) the amount (if any) by which lower tier two capital resources exceed 50% of the amount calculated at stage F of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.24

At least 75% of a firm's MCR must be accounted for by the sum of:

(1) the amount calculated at stage A plus stage B less stage E of the calculation in PRU 2.2.14 R; and
(2) the amount calculated at stage G of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.25

PRU 2.2.23 R and PRU 2.2.24 R give effect to the Insurance Directives' requirements that a firm's tier two capital resources must not exceed its tier one capital resources and that no more than 25% of a firm's "required solvency margin" should consist of lower tier two capital resources.

31/10/2004

PRU 2.2.26

A firm that carries on both long-term insurance business and general insurance business must apply the limits in PRU 2.2.16 R to PRU 2.2.24 R separately for each type of business.

31/10/2004

Characteristics of tier one capital

PRU 2.2.27

A firm may not include a share in, or another investment in, or external contribution to the capital of, that firm in its tier one capital resources unless it complies with the following conditions:

(1) it is included in one of the categories in PRU 2.2.28 R;
(2) it is not excluded by any of the rules in PRU 2.2; and
(3) it complies with the conditions set out in PRU 2.2.29 R.

31/10/2004

PRU 2.2.28

The categories referred to in PRU 2.2.27 R (1) are:

(1) permanent share capital;
(2) a perpetual non-cumulative preference share; and
(3) an innovative tier one instrument.

31/10/2004

PRU 2.2.29

Subject to PRU 2.2.30 R, an item of capital in a firm complies with PRU 2.2.27 R (3) if:

(1) it is issued by the firm;
(2) it is fully paid and the proceeds of issue are immediately and fully available to the firm;
(3) it:

(a) cannot be redeemed at all or can only be redeemed on a winding up of the firm; or
(b) complies with the conditions in PRU 2.2.38 R and PRU 2.2.39 R;

(4) any coupon is either non-cumulative or, if it is cumulative, it complies with PRU 2.2.40 R;
(5) it is able to absorb losses to allow the firm to continue trading and in the case of an innovative tier one instrument it complies with PRU 2.2.56 R to PRU 2.2.58 R;
(6) it ranks for repayment upon winding up no higher than a share of a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share);
(7) the firm has the right to choose whether or not to pay a coupon on it in cash at any time;
(8) the description of its characteristics used in its marketing is consistent with the characteristics required to satisfy PRU 2.2.29 R (1) to PRU 2.2.29 R (7).

31/10/2004

PRU 2.2.30

(1) An item of capital does not comply with PRU 2.2.27 R (3) if the issue of that item of capital by the firm is connected with one or more other transactions which, when taken together with the issue of that item, could produce the effect described in (2).
(2) The effect referred to in (1) is a reduction in the economic benefit intended to be conferred on the firm by the issue of the item of capital which means that the item of capital no longer displays all of the characteristics set out in PRU 2.2.29 R (1) to (8).

31/10/2004

PRU 2.2.31

An item of capital does not comply with PRU 2.2.29 R (5) if the holder of that item does not bear losses to at least the same degree as the holder of a share of a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share).

31/12/2004

PRU 2.2.32

PRU 2.2.29 R (2) is stricter than the Companies Act definition of fully paid, which only requires an undertaking to pay.

31/10/2004

PRU 2.2.33

An item of capital does not comply with PRU 2.2.29 R (8) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier two instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

31/10/2004

PRU 2.2.34

For the purposes of PRU 2.2.30 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

31/12/2004

PRU 2.2.35

A firm may not include a share in its tier one capital resources unless (in addition to complying with the other relevant rules in PRU 2.2):

(1) (in the case of a firm that is a company as defined in the Companies Act 1985 or the Companies (Northern Ireland) Order 1986) it is "called-up share capital" within the meaning given to that term in that Act or, as the case may be, that Order; or
(2) (in the case of any other firm) it is:

(a) in economic terms; and
(b) in its characteristics as capital (including loss absorbency, permanency, ranking for repayment and fixed costs);

substantially the same as called-up share capital falling into (1).

31/10/2004

Core tier one capital: permanent share capital

PRU 2.2.36

Permanent share capital means an item of capital which (in addition to satisfying PRU 2.2.29 R) meets the following conditions:

(1) it is:

(a) an ordinary share; or
(b) a members' contribution; or
(c) part of the initial fund of a mutual;

(2) any coupon on it is not cumulative, and the firm has both the right to choose whether or not to pay a coupon and the right to choose the amount of that coupon ; and
(3) the terms upon which it is issued do not permit redemption and it is otherwise incapable of being redeemed to at least the degree of an ordinary share issued by a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share).

31/10/2004

PRU 2.2.37

PRU 2.2.36 R has the effect that the firm should be under no obligation to make any payment in respect of a tier one instrument if it is to form part of its permanent share capital unless and until the firm is wound up. A tier one instrument that forms part of permanent share capital could not therefore count as a liability before the firm is wound up. The fact that relevant company law permits the firm to make earlier repayment does not mean that the tier one instruments are not eligible. However, the firm should not be required by any contractual or other obligation arising out of the terms of that capital to repay permanent share capital. Similarly a tier one instrument may still qualify if company law allows dividends to be paid on this capital, provided the firm is not contractually or otherwise obliged to pay them. There should therefore be no fixed costs.

31/10/2004

Basic rules about redemption and cumulative coupons

PRU 2.2.38

In relation to a perpetual non-cumulative preference share which is redeemable, a firm may not include it in its tier one capital resources unless its contractual terms are such that:

(1) it is redeemable only at the option of the firm; and
(2) the firm cannot exercise that redemption right:

(a) on or before the fifth anniversary of its date of issue;
(b) unless it has given notice to the FSA in accordance with PRU 2.2.72 R; and
(c) unless at the time of exercise of that right it complies with PRU 2.1.9 R and will continue to do so after redemption.

31/10/2004

PRU 2.2.39

In relation to an innovative tier one instrument which is redeemable and which, either:

(1) is or may become subject to a step-up; or
(2) satisfies PRU 2.2.54 R (2);

a firm may not include it in its tier one capital resources unless it complies with the conditions in PRU 2.2.38 R, except that in PRU 2.2.38 R (2)(a) "fifth anniversary" is replaced by "tenth anniversary".

31/10/2004

PRU 2.2.40

A potential tier one instrument with a cumulative coupon complies with PRU 2.2.29 R (4) only if any such coupon must, if deferred, be paid by the firm in the form of permanent share capital.

31/10/2004

PRU 2.2.41

PRU 2.2.38 R does not apply to permanent share capital because no item of capital that is either redeemable or that has a cumulative coupon can be permanent share capital.

31/12/2004

Further guidance on redemption

PRU 2.2.42

The rules in PRU 2.2 about redemption of potential tier one instruments fall into three classes:

(1) rules defining whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all;
(2) rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital; and
(3) rules defining whether a firm's potential tier one instruments must be classified as innovative tier one instruments.

31/10/2004

PRU 2.2.43

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

(1) PRU 2.2.29 R (3) and PRU 2.2.39 R have the following provisions.

(a) Any capital instrument that is redeemable at the option of the holder cannot form part of a firm's tier one capital resources. Instead, if it is redeemable at all, a capital instrument should only be redeemable at the option of the firm.
(b) A redemption right should be exercisable no earlier than the fifth anniversary of the date of issue. However, if an instrument is an innovative tier one instrument which is subject to a step-up or any other economic incentive to redeem, any such redemption should be exercisable no earlier than the tenth anniversary.
(c) Any redemption proceeds should be payable only in cash or in shares.
(d) The terms of the capital instrument should provide that any redemption right should not be exercised unless and until the firm has given the notice to the FSA required under PRU 2.2.72 R.
(e) Any redemption right should not be exercisable unless both before and after the redemption the firm complies with PRU 2.1.9 R (which requires that a firm has sufficient capital resources to meet its capital resources requirement).

(2) Under PRU 2.2.70 R, a firm should not include a potential tier one instrument that is redeemable in whole or in part in permanent share capital in its tier one capital resources unless the firm has:

(a) sufficient permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet any redemption obligations that have become due; and
(b) a prudent reserve of permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet possible future redemption obligations.

(3) PRU 2.2.65 R contains limits on the amount of permanent share capital that may be issued on a redemption of a potential tier one instrument redeemable in permanent share capital.

31/10/2004

PRU 2.2.44

The rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital are to be found in PRU 2.2.36 R. As far as redemption is concerned, it says that the capital instrument should be no more capable of being redeemed than a share under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986. PRU 2.2.38 R (which sets out the basic rules for redemption) does not apply to permanent share capital as a redeemable potential tier one instrument should not be included in permanent share capital.

31/10/2004

PRU 2.2.45

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows.

(1) Under PRU 2.2.53 R, a redeemable potential tier one instrument is always treated as an innovative tier one instrument if the redemption proceeds are payable otherwise than in cash.
(2) Under PRU 2.2.54 R, any feature of a tier one instrument that in conjunction with a call would make a firm more likely to redeem it or to have an incentive to do so will make it an innovative tier one instrument.
(3) Under PRU 2.2.62 R a step-up coupled with a right of redemption results in a potential tier one instrument being treated as an innovative tier one instrument.

31/10/2004

Further guidance on coupons

PRU 2.2.46

The rules in PRU 2.2 about the coupons payable on potential tier one instruments fall into the same three classes that apply to the rules on redemption, as set out in PRU 2.2.42 G.

31/10/2004

PRU 2.2.47

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

(1) Under PRU 2.2.29 R (4) and PRU 2.2.40 R, any deferred cumulative coupon should only be payable in permanent share capital. If a cumulative coupon is payable on a potential tier one instrument in another form, it should not be included in the firm's tier one capital resources.
(2) Under PRU 2.2.29 R (7), the firm has the right not to pay a coupon in cash at any time.
(3) PRU 2.2.63 R says that a potential tier one instrument that may be subject to a step-up that potentially exceeds defined limits should not be included in the firm's tier one capital resources. PRU 2.2.64 R says that any step-up should not arise before the tenth anniversary of the date of issue if it is to be included in the firm's tier one capital resources.
(4) The provisions of PRU 2.2.70 R summarised in PRU 2.2.43 G (2) also apply to the payment of coupons.

31/10/2004

PRU 2.2.48

PRU 2.2.36 R (2) says that a capital instrument on which a cumulative coupon is payable must not be included in a firm's permanent share capital. The payment of a coupon must be purely discretionary.

31/10/2004

PRU 2.2.49

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows:

(1) Under PRU 2.2.60 R a potential tier one instrument with a cumulative coupon is an innovative tier one instrument.
(2) Under PRU 2.2.40 R a potential tier one instrument with a coupon that if deferred must be paid in permanent share capital is an innovative tier one instrument.
(3) Under PRU 2.2.62 R a step-up coupled with a right of redemption by the firm results in a potential tier one instrument being treated as an innovative tier one instrument.

31/10/2004

Perpetual non-cumulative preference shares

PRU 2.2.50

A perpetual non-cumulative preference share may be included at stage B of the calculation in PRU 2.2.14 R if:

(1) it complies with PRU 2.2.29 R, PRU 2.2.35 R and PRU 2.2.38 R;
(2) any coupon on it is not cumulative, and the firm has the right to choose whether or not to pay a coupon in all circumstances;
(3) it is not excluded from tier one capital resources by any of the rules in PRU 2.2; and
(4) it is not an innovative tier one instrument.

31/10/2004

PRU 2.2.51

Perpetual non-cumulative preference shares should be perpetual and redeemable only at the firm's option. Any feature that, in conjunction with a call, would make a firm more likely to redeem perpetual non-cumulative preference shares would normally result in classification as an innovative tier one instrument. Such features would include, but not be limited to, a step-up, bonus coupon on redemption or redemption at a premium to the original issue price of the share.

31/10/2004

Innovative tier one instruments: general rules

PRU 2.2.52

If an item of capital is stated to be an innovative tier one instrument by the rules in PRU 2.2, it cannot be included in stages A or B of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.53

If a tier one instrument is redeemable at the option of the firm, it is an innovative tier one instrument unless it is redeemable solely in cash.

31/10/2004

PRU 2.2.54

If a tier one instrument:

(1) is redeemable; and
(2) is issued on terms that are (or its terms are amended and the amended terms are) such that a reasonable person would (judging at or around the time of issue or amendment) think that:

(a) the firm is likely to redeem it; or
(b) the firm is likely to have a substantial economic incentive to redeem it;

that tier one instrument is an innovative tier one instrument.

31/10/2004

PRU 2.2.55

Any feature that in conjunction with a call would make a firm more likely to redeem a tier one instrument would normally result in classification as innovative tier one capital resources. Innovative tier one instruments include but are not limited to those incorporating a step-up or principal stock settlement.

31/10/2004

Innovative tier one instruments: loss absorbency

PRU 2.2.56

A capital instrument may only be included in innovative tier one capital resources if a firm's obligations under the instrument either:

(1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
(2) do constitute such a liability but the terms of the instrument are such that:

(a) any such liability is not relevant for the purposes of deciding whether:

(i) the firm is, or is likely to become, unable to pay its debts; or
(ii) its liabilities exceed its assets;

(b) a creditor (including, but not limited to, a holder of the instrument) is not able to petition for the winding up or administration of the firm on the grounds that the firm is or may become unable to pay any such liability; and
(c) the firm is not obliged to take into account such a liability for the purposes of deciding whether or not the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful trading).

31/10/2004

PRU 2.2.57

The effect of PRU 2.2.56 R is that if a potential tier one instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As tier one capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

31/10/2004

PRU 2.2.58

A firm wishing to issue an innovative tier one instrument must obtain an opinion from Queen's Counsel, or where the opinion relates to the law of a jurisdiction outside the United Kingdom, from a lawyer in that jurisdiction of equivalent status, confirming that the criteria in PRU 2.2.29 R (5) and PRU 2.2.31 R are met.

31/10/2004

PRU 2.2.59

The holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

31/10/2004

Innovative tier one instruments: Coupons

PRU 2.2.60

A tier one instrument with a cumulative coupon which complies with PRU 2.2.40 R is an innovative tier one instrument.

31/10/2004

PRU 2.2.61

An item of capital does not fall into PRU 2.2.60 R merely because a firm has come under an obligation to pay a particular coupon in permanent share capital where that obligation is the result of a voluntary election by the holder or the firm to be paid the coupon in that form. Thus, for example, if a shareholder of a firm is allowed to elect to be paid a dividend in the form of a conventional scrip dividend, that does not make the share into an innovative tier one instrument.

31/10/2004

Innovative tier one instruments and other tier one instruments: step-ups

PRU 2.2.62

If:

(1) a potential tier one instrument is or may become subject to a step-up; and
(2) that potential tier one instrument is redeemable at any time (whether before, at or after the time of the step-up);

that potential tier one instrument is an innovative tier one instrument.

31/10/2004

PRU 2.2.63

If a potential tier one instrument is or may become subject to a step-up, a firm must not include it in its tier one capital resources if the amount of the step-up exceeds or may exceed;

(1) 100 basis points; and
(2) 50% of the initial credit spread.

31/10/2004

PRU 2.2.64

A firm must not include a potential tier one instrument that is or may become subject to a step-up in its tier one capital resources if the step-up can arise earlier than the tenth anniversary of the date of issue of that item of capital.

31/10/2004

Innovative tier one instruments: principal stock settlement

PRU 2.2.65

A firm must not include a potential tier one instrument that is redeemable in whole or in part in permanent share capital in its tier one capital resources if:

(1) the conversion ratio as at the date of redemption may be greater than the conversion ratio as at the time of issue by more than 200%; or
(2) the issue or market price of the conversion instruments issued in relation to one unit of the original capital item (plus any cash element of the redemption) may be greater than the issue price (or, as the case may be, market price) of that original capital item.

31/10/2004

PRU 2.2.66

In PRU 2.2.65 R to PRU 2.2.69 R:

(1) the original capital item means the capital item that is being redeemed; and
(2) the conversion instrument means the permanent share capital issued on its redemption.

31/10/2004

PRU 2.2.67

In PRU 2.2.65 R to PRU 2.2.69 R, the conversion ratio means the ratio of:

(1) the number of units of the conversion instrument that the firm must issue to satisfy its redemption obligation (so far as it is to be satisfied by the issue of conversion instruments) in respect of one unit of the original capital item; to
(2) one unit of the original capital item.

31/10/2004

PRU 2.2.68

In PRU 2.2.65 R, the conversion ratio as at the date of issue of the original capital item is calculated as if the original capital item were redeemable at that time.

31/10/2004

PRU 2.2.69

If the conversion instruments or the original capital item are subdivided or consolidated or subject to any other occurrence that would otherwise result in like not being compared with like, the conversion ratio calculation in PRU 2.2.65 R must be adjusted accordingly.

31/12/2004

Requirement to have sufficient unissued stock

PRU 2.2.70

(1) This rule applies to a potential tier one instrument of a firm where either:

(a) the redemption proceeds; or
(b) any coupon on that capital item;

can be satisfied by the issue of another tier one instrument.
(2) A firm may only include an item of capital to which this rule applies in its tier one capital resources if the firm has authorised and unissued tier one instruments of the kind in question (and the authority to issue them):

(a) that are sufficient to satisfy all such payments then due; and
(b) are of such amount as is prudent in respect of such payments that could become due in the future.

31/10/2004

Notifying the FSA of the issue and redemption of tier one instruments

PRU 2.2.71

A firm must not include any perpetual non-cumulative preference shares or innovative tier one instruments in its tier one capital resources for the purpose of PRU 2.2 unless it has notified the FSA of its intention at least one month before it first includes them.

31/10/2004

PRU 2.2.72

A firm must not redeem any tier one instrument that it has included in its tier one capital resources for the purpose of PRU 2.2 unless it has notified the FSA of its intention at least one month before it does so.

31/12/2004

Non standard capital instruments

PRU 2.2.73

There may be examples of capital instruments that, although based on a standard form, contain structural features that make the rules in PRU 2.2 difficult to apply. In such circumstances, a firm may seek individual guidance on the application of those rules to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

31/10/2004

Step-ups

PRU 2.2.74

In relation to a tier one instrument, a step-up means any change in the coupon rate on that instrument that results in an increase in the amount payable at any time, including a change already provided in the original terms governing those payments. A step-up:

(1) includes (in the case of a fixed rate) an increase in that coupon rate;
(2) includes (in the case of a floating rate calculated by adding a fixed amount to a fluctuating amount) an increase in that fixed amount;
(3) includes (in the case of a floating rate) a change in the identity of the benchmark by reference to which the fluctuating element of the coupon is calculated that results in an increase in the absolute amount of the coupon;
(4) does not include (in the case of a floating rate) an increase in the absolute amount of the coupon caused by fluctuations in the fluctuating figure by reference to which the absolute amount of the coupon floats.

31/10/2004

PRU 2.2.75

Where a rule in PRU 2.2 says that a particular treatment applies to an item of capital that is subject to a step-up of a specified amount, the question of whether that rule is satisfied must be judged by reference to the cumulative amount of all step-ups since the issue of that item of capital rather than just by reference to a particular step-up.

31/10/2004

Profit and loss account and other reserves

PRU 2.2.76

Negative amounts, including any interim net losses, must be deducted from tier one capital resources.

31/10/2004

PRU 2.2.77

Dividends must be deducted from reserves as soon as they are declared.

31/10/2004

Valuation differences

PRU 2.2.78

Valuation differences are all differences between the valuation of assets and liabilities as valued in PRU and the valuation that the firm uses for its external financial reporting purposes, except valuation differences which are dealt with elsewhere in PRU 2.2.14 R. The sum of these valuation differences must either be added to (if positive) or deducted from (if negative) a firm's capital resources in accordance with PRU 2.2.14 R.

31/10/2004

PRU 2.2.79

Additions to and deductions from capital resources will arise from the application of asset and liability valuation and admissibility rules (see PRU 1.3, PRU 2.2.86 R and PRU 2 Annex 1R). Downward adjustments include discounting of technical provisions for general insurance business (which is optional for financial reporting but not permitted for regulatory valuation - see PRU 2.2.80 R to PRU 2.2.81 R) and derecognition of any defined benefit asset in respect of a defined benefit occupational pension scheme (see PRU 1.3.5B R). Details of valuation differences relating to technical provisions and liability adjustments for long-term insurance business are set out in PRU 7.3. In particular, contingent loans or other arrangements which are not valued as a liability under PRU 7.3.79R (2) result in a positive valuation difference.

21/04/2005
Past version of PRU 2.2.79 before 21/04/2005

PRU 2.2.80

PRU 2.2.81 R applies to a firm that carries on general insurance business, except a pure reinsurer, and which discounts or reduces its technical provisions for claims outstanding.

21/04/2005
Past version of PRU 2.2.80 before 21/04/2005

PRU 2.2.81

A firm of a kind referred to in PRU 2.2.80 R must deduct from its capital resources the difference between the undiscounted technical provisions or technical provisions before deductions and the discounted technical provisions or technical provisions after deductions. This adjustment must be made for all general insurance business classes, except for risks listed under classes 1 and 2. For classes other than 1 and 2, no adjustment needs to be made in respect of the discounting of annuities included in technical provisions. For classes 1 and 2 (other than annuities), if the expected average interval between the settlement date of the claims being discounted and the accounting date is not at least four years, the firm must deduct:

(1) the difference between the undiscounted technical provisions and the discounted technical provisions; or
(2) where it can identify a subset of claims such that the expected average interval between the settlement date of the claims and the accounting date is at least four years, the difference between the undiscounted technical provisions and the discounted technical provisions for the other claims.

21/04/2005
Past version of PRU 2.2.81 before 21/04/2005

Externally verified interim net profits

PRU 2.2.82

Externally verified interim net profits are interim profits verified by a firm's external auditors after deduction of tax, declared dividends and other appropriations.

31/10/2004

PRU 2.2.83

The FSA may request a firm to provide it with a copy of the external auditor's opinion on whether the interim profits are fairly stated.

31/10/2004

Intangible assets

PRU 2.2.84

A firm must deduct from its tier one capital resources the value of intangible assets.

31/10/2004

PRU 2.2.85

Intangible assets include goodwill, capitalised development costs, brand names, trademarks and similar rights, and licences.

31/10/2004

Inadmissible assets

PRU 2.2.86

For the purposes of PRU 2.2.14 R, a firm must deduct from total capital resources the value of any asset which is not an admissible asset as listed in PRU 2 Annex 1 R.

31/10/2004

PRU 2.2.87

PRU 2.2.86 R does not apply to intangible assets which must be deducted from tier one capital resources under PRU 2.2.84 R.

31/10/2004

PRU 2.2.88

The list of admissible assets has been drawn with the aim of excluding assets:

(1) for which a sufficiently objective and verifiable basis of valuation does not exist; or
(2) whose realisability cannot be relied upon with sufficient confidence; or
(3) whose nature presents an unacceptable custody risk; or
(4) the holding of which may give rise to significant liabilities or onerous duties.

31/10/2004

Adjustments for related undertakings

PRU 2.2.89

A firm must deduct from its capital resources the value of its investments in each of its related undertakings that is an ancillary services undertaking.

31/10/2004

PRU 2.2.90

In relation to each of its related undertakings that is a regulated related undertaking (other than an insurance undertaking) a firm must add to (if positive), at stage J in PRU 2.2.14 R, or deduct from (if negative), at stage L in PRU 2.2.14 R, its capital resources the value of its shares in that undertaking calculated in accordance with PRU 1.3.35 R.

31/10/2004

PRU 2.2.91

For the purposes of PRU 2.2.89 R, investments must be valued at their accounting book value in accordance with PRU 1.3.5 R.

31/10/2004

PRU 2.2.92

Related undertakings which are also insurance undertakings are not included in PRU 2.2.90 R because a firm that is a participating insurance undertaking is subject to the requirements of PRU 8.3.

31/10/2004

Additional requirements for a tier one or tier two instrument issued by a firm carrying on with-profits insurance business

PRU 2.2.93

A firm carrying on with-profits insurance business must, in addition to the other requirements in respect of capital resources elsewhere in PRU 2.2, meet the following conditions before a capital instrument can be included in the firm's capital resources:

(1) the firm must manage the with-profits fund so that discretionary benefits under a with-profits insurance contract are calculated and paid disregarding, insofar as is necessary for its customers to be treated fairly, any liability the firm may have to make payments under the capital instrument;
(2) the intention to manage the with-profits fund on the basis set out in PRU 2.2.93 R (1) must be disclosed in the firm's Principles and Practices of Financial Management; and
(3) no amounts, whether interest, principal, or other amounts, must be payable by the firm under the capital instrument if the firm's assets would then be insufficient to enable it to declare and pay under a with-profits insurance contract discretionary benefits that are consistent with the firm's obligations under Principle 6.

31/10/2004

PRU 2.2.94

The purpose of PRU 2.2.93 R is to achieve practical subordination of capital instruments if they are to qualify as capital resources to the liabilities a firm has to with-profits policyholders, including liabilities which arise from the regulatory duty to treat customers fairly in setting discretionary benefits. (Principle 6 (Customers' interests) requires a firm to pay due regard to the interests of its customers and treat them fairly.) It is not sufficient for a capital instrument to be subordinated to such liabilities only on winding up of the firm because such liabilities to policyholders may have been reduced by the inappropriate use of management discretion to enable funds to be applied in repaying subordinated capital instruments before winding up proceedings commence.

31/10/2004

PRU 2.2.95

PRU 2.2.93 R is an additional requirement to all other rules in PRU 2.2 concerning the eligibility of a capital instrument to count as a component of a firm's capital resources. Subordinated debt instruments will be the main type of capital instrument to which this rule is relevant, including both upper tier two (undated) and lower tier two (dated) subordinated debt instruments. Subordinated debt instruments which are issued by a related undertaking are not intended to be covered by this rule and may be included in group capital resources as appropriate if the other eligibility criteria are met.

31/10/2004

PRU 2.2.96

PRU 2.2.29 R (8) and PRU 2.2.108 R (10) contain provisions concerning the marketing of a capital instrument. In relation to a firm to which PRU 2.2.93 R applies, in order to comply with PRU 2.2.29 R (8) and PRU 2.2.108 R (10), it should draw to the attention of subscribers the risk that payments may be deferred or cancelled in order to operate the with-profits fund so as to give priority to the payment of discretionary benefits to with-profits policyholders.

31/10/2004

PRU 2.2.97

(1) Upper tier two instruments must meet the requirements of PRU 2.2.101 R (3) which goes beyond the requirement in PRU 2.2.93 R (3) since it requires a firm to have the option to defer payments in all circumstances, not just if necessary to treat customers fairly. However, for lower tier two instruments, PRU 2.2.93 R (3) represents an additional requirement since a failure to pay amounts of interest or principal on a due date must not constitute an event of default under PRU 2.2.108 R (2) for firms carrying on with-profits insurance business.
(2) For firms which are realistic basis life firms compliance with PRU 2.2.93 R (3) would usually be achieved if the capital instrument provides that no amounts will be payable under it unless the firm's capital resources exceed its capital resources requirement. However, such firms should ensure that the terms of the capital instrument refer to FSA capital resources requirements in force from time to time, including the current realistic reserving requirements and are not restricted to former minimum capital requirements based only on the Insurance Directives' required minimum margin of solvency. For firms which are not realistic basis life firms, compliance with PRU 2.2.93 R (3) will probably require specific reference to be made to treating customers fairly in the terms of the capital instrument.

31/10/2004

Tier two capital

PRU 2.2.98

Tier two capital resources is split into upper and lower tiers. The principal distinction between upper and lower tier two capital is that perpetual instruments may be included in upper tier two capital whereas dated instruments, such as fixed term preference shares and dated subordinated debt, are included in lower tier two capital.

31/10/2004

PRU 2.2.99

Tier two capital instruments are capital instruments that combine the features of debt and equity in that they are structured like debt, but exhibit some of the loss absorption and funding flexibility features of equity.

31/10/2004

Upper tier two capital

PRU 2.2.100

Examples of capital instruments which may be eligible to count in upper tier two capital resources include the following:

(1) perpetual cumulative preference shares;
(2) perpetual subordinated debt; and
(3) other instruments that have the same economic characteristics as (1) or (2).

31/10/2004

PRU 2.2.101

A capital instrument must meet the following conditions before it can be included in a firm's upper tier two capital resources:

(1) it must meet the general conditions described in PRU 2.2.108 R;
(2) it must have no fixed maturity date;
(3) the contractual terms of the instrument must provide for the firm to have the option to defer any interest payment in cash on the debt; and
(4) the contractual terms of the instrument must provide for the loss-absorption capacity of the debt and unpaid interest, whilst enabling the firm to continue its business.

31/10/2004

PRU 2.2.102

A capital instrument does not meet PRU 2.2.101 R (4) unless it meets PRU 2.2.103 R and PRU 2.2.105 R.

31/10/2004

PRU 2.2.103

A capital instrument may only be included in upper tier two capital resources if a firm's obligations under the instrument either:

(1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
(2) do constitute such a liability but the terms of the instrument are such that:

(a) any such liability is not relevant for the purposes of deciding whether:

(i) the firm is, or is likely to become, unable to pay its debts; or
(ii) its liabilities exceed its assets;

(b) a creditor (including but not limited to a holder of the instrument) is not able to petition for the winding up or administration of the firm on the grounds that the firm is or may become unable to pay any such liability; and
(c) the firm is not obliged to take into account such a liability for the purposes of deciding whether or not the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful trading).

31/10/2004

PRU 2.2.104

The effect of PRU 2.2.103 R is that if an upper tier two instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As upper tier two capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

31/10/2004

PRU 2.2.105

A firm wishing to issue an upper tier two instrument other than a perpetual cumulative preference share must obtain an opinion from Queen's Counsel, or where the opinion relates to the law of a jurisdiction outside the United Kingdom, from a lawyer in that jurisdiction of equivalent status, confirming that the criteria in PRU 2.2.101 R (4) are met.

31/10/2004

PRU 2.2.106

For the purpose of PRU 2.2.103 R (2)(b) above, the holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

31/10/2004

Lower tier two capital

PRU 2.2.107

Capital instruments that meet the general conditions described in PRU 2.2.108 R may be included in lower tier two capital resources.

31/10/2004

General conditions for eligibility as tier two capital

PRU 2.2.108

A capital instrument must not form part of the tier two capital resources of a firm unless it meets the following conditions:

(1) the claims of the creditors must rank behind those of all unsubordinated creditors;
(2) the only events of default must be non-payment of any amount falling due under the terms of the capital instrument or the winding-up of the firm;
(3) the remedies available to the subordinated creditor in the event of non-payment or other breach of the written agreement or instrument must be limited to petitioning for the winding-up of the firm or proving for the debt and claiming in the liquidation of the firm;
(4) any events of default and any remedy described in (3) must not prejudice the matters in (1) and (2);
(5) in addition to the requirement about repayment in (1), the debt must not become due and payable before its stated final maturity date (if any) except on an event of default complying with (2);
(6) the debt agreement or terms of the capital instrument are governed by the law of England and Wales, or of Scotland or of Northern Ireland;
(7) to the fullest extent permitted under the laws of the relevant jurisdictions, creditors must waive their right to set off amounts they owe the firm against subordinated amounts included in the firm's capital resources owed to them by the firm;
(8) the terms of the capital instrument must be set out in a written agreement that contains terms that provide for the conditions set out in (1) to (7);
(9) the debt must be unsecured and fully paid up;
(10) the description of its characteristics used in its marketing is consistent with the characteristics required to satisfy (1) to (9); and
(11) the firm has obtained a properly reasoned external legal opinion stating that the requirements in (1) to (10) have been met.

31/12/2004
Past version of PRU 2.2.108 before 31/12/2004

PRU 2.2.109

For the purposes of PRU 2.2.108 R (5) the debt agreement or terms of the instrument should not contain any clause which might require early repayment of the debt (e.g. cross default clauses, negative pledges and restrictive covenants). A cross default clause is a clause which says that the loan goes into default if any of the borrower's other loans go into default. It is intended to prevent one creditor being repaid before other creditors, e.g. obtaining full repayment through the courts. A negative pledge is a clause which puts the loan into default if the borrower gives any further charge over its assets. A restrictive covenant is a term of contract that directly, or indirectly, could lead to early repayment of the debt. Some covenants, e.g. relating to the provision of management information or ownership restrictions, are likely to comply with PRU 2.2.108 R (5) as long as monetary redress is ruled out, or any payments are covered by the subordination and limitation of remedies clauses (that is, if damages are unpaid, the only remedy is to petition for a winding up).

31/10/2004

PRU 2.2.110

The purpose of PRU 2.2.108 R (7) is to ensure that all of the firm's assets are available to customers ahead of subordinated creditors. The waiver should apply both before and during liquidation.

31/10/2004

PRU 2.2.111

PRU 2.2.108 R (6) does not apply if the firm has obtained a properly reasoned external legal opinion confirming that the same degree of subordination has been achieved under the law that governs the debt and the agreement as that which would have been achieved under the laws of England and Wales, Scotland, or Northern Ireland.

31/10/2004

PRU 2.2.112

An item of capital does not comply with PRU 2.2.108 R (10) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier capital instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

31/10/2004

PRU 2.2.113

(1) An item of capital does not comply with PRU 2.2.101 R or PRU 2.2.108 R if the issue of that item of capital by the firm is connected with one or more other transactions which, when taken together with the issue of that item, could produce the effect described in (2).
(2) The effect referred to in (1) is a reduction in the economic benefit intended to be conferred on the firm by the issue of the item of capital which means that the item of capital no longer displays all of the characteristics set out in PRU 2.2.101 R or PRU 2.2.108 R.

31/10/2004

PRU 2.2.114

For the purposes of PRU 2.2.113 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

31/10/2004

PRU 2.2.115

The FSA is more concerned that the subordination provisions listed in PRU 2.2.108 R should be effective than that they should follow a particular form. The FSA does not, therefore, prescribe that the loan agreement should be drawn up in a standard form.

31/12/2004

PRU 2.2.116

A firm must not amend the terms of the debt and the documents referred to in PRU 2.2.108 R (8) unless:

(1) at least one month before the amendment is due to take effect, the firm has given the FSA notice in writing of the proposed amendment and the FSA has not objected; and
(2) that notice includes confirmation that the legal opinions referred to in PRU 2.2.108 R (11) and, if applicable, PRU 2.2.105 R and PRU 2.2.111 R, continue in full force and effect in relation to the terms of the debt and documents, notwithstanding any proposed amendment.

31/10/2004

PRU 2.2.117

A firm must notify the FSA of its intention to repay a tier two instrument at least six months before the date of the proposed repayment (unless the firm intends to repay an instrument on its contractual repayment date) providing details of how it will meet its capital resources requirement after such repayment.

31/10/2004

Step-ups

PRU 2.2.118

In relation to a tier two instrument, a step-up in a coupon rate means:

(1) (in the case of a fixed rate) an increase in that rate;
(2) (in any other case) any change in the way that the interest or other payment is calculated that may result in an increase in the amount payable at any time, including a change already provided in the original terms governing those payments.

31/10/2004

PRU 2.2.119

Where a tier two instrument is subject to one or more step-ups, the first date that a step-up can take effect must be treated, for the purposes of this section, as the instrument's final maturity date if its actual maturity date occurs after that, unless the effect of the step-up or step-ups is to increase the coupon rate at which payments are to be made by no more than:

(1) 50 basis points in the first ten years of the life of the debt; or
(2) 100 basis points over the whole life of the debt.

31/10/2004

PRU 2.2.120

A firm may not include in its tier two capital resources a capital instrument the terms of which provide for a step-up in the first five years after issue.

31/10/2004

PRU 2.2.121

Where a step-up arises through a change from paying a coupon on a debt instrument to paying a dividend on a share issued in settlement of the coupon, then any cost to the firm arising from the tax treatment of the dividend may be excluded.

31/10/2004

PRU 2.2.122

Debt instruments containing embedded options, e.g. issues containing options for the interest rate after the step-up to be at a margin over the higher of two (or more) reference rates, or for the interest rate in the previous period to act as a floor, may affect the funding costs of the borrower and imply a step-up. In such circumstances, a firm may wish to seek individual guidance on the application of the rules relating to step-ups to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

31/10/2004

PRU 2.2.123

A capital instrument may be included in lower tier two capital resources only if it has an original maturity of at least five years or, where it has no fixed maturity date, notice of repayment of not less than five years has been given.

31/10/2004

PRU 2.2.124

In its final five years to maturity, for the purposes of calculating the amount of a lower tier two instrument which may be included in a firm's capital resources, the principal amount must be amortised on a straight line basis.

31/10/2004

PRU 2.2.125

PRU 2.2.124 R applies both to a tier two instrument with a fixed maturity and to a tier two instrument with no fixed maturity but where the firm has given five years' notice of repayment.

31/10/2004

Unpaid share capital or initial funds and calls for supplementary contributions

PRU 2.2.126

Unpaid share capital or, in the case of a mutual, unpaid initial funds and calls for supplementary contributions are excluded from the capital resources of a firm except to the extent allowed in a waiver under section 148 of the Act.

31/10/2004

PRU 2.2.127

Subject to a waiver, under the Insurance Directives a maximum of one half of unpaid share capital or, in the case of a mutual, one half of the unpaid initial fund may be included in a firm's capital resources, once the paid-up part amounts to 25% of that share capital or fund, up to 50% of total capital resources.

31/12/2004

PRU 2.2.128

In the case of a mutual carrying on general insurance business and subject to a waiver, calls for supplementary contributions within the financial year may only be included in a firm's capital resources up to a maximum of 50% of the difference between the maximum contributions and the contributions actually called in, subject to a limit of 50% of total capital resources. In the case of a mutual carrying on long-term insurance business, the Consolidated Life Directive does not permit calls for supplementary contributions to be included in a firm's capital resources.

31/10/2004

PRU 2.3

Individual Capital Assessment

31/12/2004

Application

PRU 2.3.1

PRU 2.3 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

Purpose

PRU 2.3.2

Principle 4 requires a firm to maintain adequate financial resources. PRU 2 sets out provisions that deal specifically with the adequacy of that part of a firm's financial resources that consists of capital resources. The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. In PRU 2.1, the FSA sets minimum capital resources requirements for firms. It also reviews a firm's own assessment of its capital needs, and the processes and systems by which that assessment is made, in order to see if the minimum capital resources requirements are appropriate. PRU 1.2 contains rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, to assess how it intends to deal with those risks and to quantify the financial resources it considers necessary to mitigate those risks. To meet these requirements, a firm should consider the extent to which capital is an appropriate mitigant for the risks identified and assess the amount and quality of capital required. In accordance with PRU 1.2.37 R, these assessments must be documented so that they can be easily reviewed by the FSA as part of the FSA's assessment of the adequacy of the firm's capital resources.

31/12/2004

PRU 2.3.3

This section (PRU 2.3) sets out guidance on how firms should assess the adequacy of their capital resources, both to comply with the rules in PRU 1.2 and to enable the FSA better to assess whether the minimum capital resources requirements in PRU 2.1 are appropriate. This section also requires firms carrying on general insurance business to calculate their ECR. The ECR for firms carrying on general insurance business is an indicative measure of the capital resources that a firm may need to hold based on risk sensitive calculations applied to its business profile. For realistic basis life firms, the ECR forms part of the calculation of the firm's capital resources requirement (see PRU 2.1.15 R). The ECR for such firms requires the calculation of a with-profits insurance capital component (see PRU 7.4) that supplements the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In the case of firms carrying on general insurance business and realistic basis life firms, the FSA will use the ECR as a benchmark for its consideration of the appropriateness of the firm's own capital assessment. For firms where an ECR is not calculated the MCR will provide a benchmark for the firm's own capital assessment. For firms generally, the more thorough, objective and prudent a firm's capital assessment is and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment. The FSA will consider the appropriateness of the firm's capital assessment to establish the level of capital resources the firm needs. This may result in the FSA's assessment of a firm's capital resources needs being lower or higher than would otherwise be the case.

31/12/2004

PRU 2.3.4

There are two main purposes of this section:

(1) to enable firms to understand the issues which the FSA would expect to see assessed and the systems and processes which the FSA would expect to see in operation for capital adequacy assessments by the firm to be regarded as thorough, objective and prudent; and
(2) to enable firms to understand the FSA's approach to assessing whether the minimum capital resources requirements of PRU 2.1 are appropriate and what action may be taken if the FSA concludes that those requirements are not appropriate to a firm's circumstances.

31/12/2004

Main requirements and guidance

PRU 2.3.5

In making an assessment of capital adequacy, the FSA requires firms to identify the major risks they face and, where capital is appropriate to mitigate those risks, to quantify how much (and what type) of capital is appropriate. To do this, the FSA expects firms to conduct stress tests and scenario analyses in respect of each risk. For each risk the firm will then be able to estimate a range of probable outcomes and hence capital required to absorb losses which might arise. A firm must document the results of each of the stress tests and scenario analyses undertaken and should also document, as part of the details of those tests and analyses, the key assumptions including the aggregation of the results.

31/12/2004

PRU 2.3.6

The assessment which a firm makes should be based upon its future business plans and projections. This is the main area where the firm's assessment may diverge from its prescribed capital resources requirement which, necessarily, is based upon historic data.

31/12/2004

PRU 2.3.7

In assessing the quality and the amount of capital resources projected to be available to meet its projected capital resources requirement, a firm should consider the timing of its liabilities to repay existing capital together with the prospects for raising new capital in the scenarios considered.

31/12/2004

PRU 2.3.8

The FSA may ask for the results of a firm's assessment to be provided to it together with a description of the processes by which the assessment has been made, the range of results from each stress test or scenario analysis performed and the main assumptions made. The FSA may also carry out a more detailed examination of the details of the firm's processes and calculations.

31/12/2004

PRU 2.3.9

Based upon this information and other information available to the FSA, the FSA will consider whether the capital resources requirement applicable to the firm is appropriate. Where relevant, the firm's ECR will be a key input to the FSA's assessment of the adequacy of the firm's capital resources.

31/12/2004

PRU 2.3.10

A firm carrying on general insurance business, other than a non-directive insurer, must calculate the amount of its ECR.

31/12/2004

PRU 2.3.11

A firm to which PRU 2.3.10 R applies must calculate its ECR in respect of its general insurance business as the sum of:

(1) the asset-related capital requirement; and
(2) the insurance-related capital requirement; less
(3) the firm's equalisation provisions.

31/12/2004

PRU 2.3.12

Details of the calculation of the asset-related capital requirement are set out in PRU 3.3.10 R to PRU 3.3.16 R. Details of the calculation of the insurance-related capital requirement are set out in PRU 7.2.76 R to PRU 7.2.79 R.

31/12/2004

PRU 2.3.13

Where the FSA considers that a firm will not comply with PRU 1.2.22 R (adequate financial resources, including capital resources) by holding the capital resources required by PRU 2.1, the FSA may give the firm individual guidance advising it of the amount and quality of capital resources which the FSA considers it needs to hold in order to meet that rule.

31/12/2004

PRU 2.3.14

The individual guidance will be given taking into consideration capital resources consistent with a 99.5% confidence level over a one year timeframe or, if appropriate to the firm's business, an equivalent lower confidence level over a longer timeframe. Firms should therefore prepare an individual capital assessment on the same basis. Throughout whatever timeframe is adopted by firms, firms should ensure that their projected assets are, and will continue to be, sufficient, to enable their projected liabilities to be paid, and it would be reasonable for firms to test that this is the case at the end of each year of the timeframe. Firms may also wish to make estimates of capital adequacy using other assumptions for their own internal purposes and are free to do so if they so choose.

31/12/2004

PRU 2.3.15

If a firm considers that the individual guidance is inappropriate to its circumstances, then the firm should inform the FSA that it does not intend to follow that guidance. Informing the FSA of such an intention would be expected if a firm is to comply with Principle 11 (relations with regulators).

31/12/2004

PRU 2.3.16

The FSA expects most disagreements about the adequacy of capital will be resolved through further analysis and discussion. The FSA may consider the use of its powers under section 166 of the Act (Reports by skilled persons) to assist in such circumstances. If the FSA and the firm still do not agree on an adequate level of capital, then the FSA may consider using its powers under section 45 of the Act to, on its own initiative, vary a firm's Part IV permission so as to require it to hold capital in accordance with the FSA's view of the capital necessary to comply with PRU 1.2.22 R. SUP 7 provides further information about the FSA's powers under section 45.

31/12/2004

PRU 2.3.17

Where a firm or the FSA considers that the capital resources requirements of PRU 2.1 require the holding of more capital than is needed for the firm to comply with PRU 1.2.22 R then the firm may apply to the FSA for a waiver of the requirements in PRU 2.1 under section 148 of the Act. This section sets out the factors which the FSA will consider in deciding whether to grant such a waiver request, and if so, the terms and extent of any modification to the rules in PRU 2.1. In addition to the statutory tests under section 148, these will include the thoroughness, objectivity, and prudence of a firm's own capital assessment and the extent to which the guidance in this section has been followed. The FSA will not grant a waiver that would cause a breach of the minimum capital requirements under the Insurance Directives.

31/12/2004

Stress and scenario requirement

PRU 2.3.18

PRU 1.2.35 R requires a firm to carry out stress tests and scenario analyses for each of the sources of risk identified in accordance with PRU 1.2.31 R. Using each of the risk categories set out in PRU 1.2.31 R, PRU 2.3.19 G to PRU 2.3.34 G set out the factors that a firm should consider. PRU 2 Ann 3 G provides a practical illustration of how a small firm carrying on general insurance business might undertake this analysis.

31/12/2004

Factors to consider when assessing credit risk

PRU 2.3.19

Credit risk refers to the risk of loss if another party fails to perform its obligations or fails to perform them in a timely fashion.

31/12/2004

PRU 2.3.20

In assessing potential credit risk events that may affect the firm's solvency, a firm should allow for:

(1) the financial effect of non-payment of reinsurance, considering the likelihood both of non-payment of outstanding claims and for the fact that reinsurance cover purchased for underwritten risks may not be effective (that is, offsetting potential liabilities); and
(2) the financial effect of non-payment of premium debtors such as intermediaries and policyholders.

31/12/2004

PRU 2.3.21

Some further areas to consider in developing the credit risk stress tests and scenario analyses might include:

(1) the adequacy of the reinsurance programme and whether it is appropriate for the risks selected by the firm and adequately takes account of the underwriting and business plans of the firm generally;
(2) the collapse of a reinsurer or several reinsurers on the firm's reinsurance programme and the subsequent impact this may have on the firm's outstanding reinsurance recoveries and IBNR recoveries;
(3) a deterioration in the creditworthiness of the firm's reinsurers, intermediaries or other counterparties;
(4) the degree of credit concentration. For example, the degree to which a firm is exposed to a single counterparty or group;
(5) the degree of concentration of exposure to reinsurers of particular rating grades;
(6) the prospect of reinsurance rates increasing substantially or reinsurance being unavailable;
(7) any existing or possible future disputes relating to reinsurance contracts on a pessimistic basis and the extent that they are not already reflected in the value attributed to the reinsurances;
(8) greater losses from bad debts than anticipated;
(9) deterioration in the extent and quality of collateral; and
(10) guarantees given by the insurer of the performance of others, whether under contracts of insurance or otherwise.

31/12/2004

Factors to consider when assessing market risk

PRU 2.3.22

Market risk includes the risks that arise from fluctuations in values of, or income from, assets or in interest or exchange rates.

31/12/2004

PRU 2.3.23

In assessing potential market risk events that may affect the firm's solvency, a firm should allow for:

(1) reduced market values of investments;
(2) variation in interest rates and the effect on the market value of investments;
(3) a lower level of investment income than planned; and
(4) the possibility of counterparty defaults.

31/12/2004

PRU 2.3.24

Some further areas to consider in developing the market risk scenario might include:

(1) the possibility of a severe economic or market downturn or upturn leading to adverse interest rate movements affecting the firm's investment position;
(2) unanticipated losses and defaults of issuers;
(3) price shifts in asset classes, and their impact on the entire portfolio;
(4) inadequate valuation of assets;
(5) the direct impact on the portfolio of currency devaluation, as well as the effect on related markets and currencies;
(6) extent of any mismatch of assets and liabilities, including reinvestment risk;
(7) the impact on the portfolio value of a dramatic change in the spread between a market index of interest rates and the risk-free interest rates; and
(8) the extent to which market moves could have non-linear effects on values, such as derivatives.

31/12/2004

Factors to consider when assessing liquidity risk

PRU 2.3.25

In accordance with PRU 1.2.31 R a firm should consider the major sources of risk, including liquidity risks, and assess its response should each risk materialise.

31/12/2004

PRU 2.3.26

PRU 5.1 (liquidity risk systems and controls) contains evidential provisions and guidance on how firms should meet PRU 1.2.22 R for liquidity purposes.

(1) PRU 5.1.61 E states that a scenario analysis in relation to liquidity risk required under PRU 1.2.35 R should include a cash-flow projection for each scenario tested, based on reasonable estimates of the impact of that scenario on the firm's funding needs and sources.
(2) PRU 5.1.86 E states that a firm should have a contingency funding plan for taking action to ensure, so far as it can, that in each of the scenarios tested under PRU 1.2.35R (2), it would still have sufficient liquid financial resources to meet liabilities as they fall due.

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PRU 2.3.27

When assessing liquidity risk, the firm should consider the extent of mismatch between assets and liabilities and the amount of assets held in highly liquid, marketable forms should unexpected cashflows lead to a liquidity problem. The price concession of liquidating assets is a prime concern when assessing such liquidity risk and should be built into any assessment of capital adequacy.

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PRU 2.3.28

Some further areas to consider in developing the liquidity risk scenario might include:

(1) any mismatching between expected asset and liability cash flows;
(2) the inability to sell assets quickly;
(3) the extent to which the firm's assets have been pledged;
(4) the cash-flow positions generally of the firm and its ability to withstand sharp, unexpected outflows of funds via claims, or an unexpected drop in the inflow of premiums; and
(5) the possible need to reduce large asset positions at different levels of market liquidity, and the related potential costs and timing constraints.

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Factors to consider when assessing operational risk

PRU 2.3.29

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

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PRU 2.3.30

A firm may wish to refer to SYSC 3A and PRU 6.1 when carrying out its operational risk assessment.

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PRU 2.3.31

Examples of some issues that a firm might want to consider include:

(1) the likelihood of fraudulent activity occurring that may impact upon the financial or operational aspects of the firm;
(2) the obligation a firm may have to fund a pension scheme for its employees;
(3) the technological risks that the firm may be exposed to regarding its operations. For example, risks relating to both the hardware systems and the software utilised to run those systems;
(4) the reputational risks to which the firm is exposed. For example, the impact on the firm if the firm's brand is damaged resulting in a loss of policyholders from the underwriting portfolio;
(5) the marketing and distribution risks that the firm may be exposed to. For example, the dependency on intermediary business or a firm's own sales force;
(6) the impact of legal risks. For example a non-insurance related legal action being pursued against the firm;
(7) the management of employees - for instance staff strikes, where dissatisfied staff may withdraw goodwill and may indulge in fraud or acts giving rise to reputational loss;
(8) the resourcing of key functions such as the risk management function by staff in appropriate numbers and with an appropriate mix of skills such as underwriting, claims handling, accounting, actuarial and legal expertise.

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PRU 2.3.32

A firm may consider that investigation of operational weaknesses and corrective action is a better response than holding capital and may consider that a certain degree of operational risk is within its pre-defined risk tolerance. However, until the firm corrects any identified deficiencies a firm should consider capital as a (interim) response to the risk.

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Factors to consider when assessing insurance risk

PRU 2.3.33

As a result of the differences between the nature of general and long-term insurance business, some aspects of the risk assessment vary depending on the type of business written. In assessing potential insurance risk events that may affect the firm's solvency, general and long-term insurance business firms should:

(1) analyse the potential for catastrophic losses, including both risk and event losses, the cost of reinstatement premiums and any possible reinsurance exhaustion; and
(2) determine the likelihood of any other feature of insurance risk that may lead to a variation in projected outcomes.
(3) Firms carrying on general insurance business should in addition:

(a) analyse the potential for claims reserves to deteriorate beyond the current reserving level; and
(b) determine the effect of loss ratios being higher than planned by analysing historic loss ratio experience and volatility.

(4) Firms carrying on long-term insurance business should in addition:

(a) analyse the potential for mathematical reserves subsequently to prove inadequate compared with the current reserving level; and
(b) determine the effect of claims experience being more costly than planned by analysing historic claims experience, volatility and trends in experience.

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PRU 2.3.34

Some further areas to consider in developing the insurance risk scenario might include:

(1) For underwriting risks, general insurance business and long-term insurance business firms:

(a) the adequacy of the firm's pricing. For example, the firm should be able to satisfy itself that it can charge adequate rates, taking into account the business and the risk profile of different products, the business environment (e.g. premium cycle-non-life) and its own internal profit targets;
(b) the uncertainty of claims experience;
(c) the dependence on intermediaries for a disproportionate share of the insurer's premium income; the effects of a high level of uncertainty in pricing in new or emerging underwriting markets due to a lack of information needed to enable the insurer to make a proper assessment of the price of the risk; the geographical mix of the portfolio or whether any geographical or jurisdictional concentrations exist;
(d) the appropriateness of policy wordings;
(e) the risk of mis-selling, for example, the number of complaints or disputed claims; and
(f) the tolerance for expense reserve variations or variations in expenses (including indirect costs).

(2) For firms carrying on general insurance business, in addition:

(a) the length of tail of the claims development and latent claims; and
(b) the effects of rapid growth or decline in the volume of the underwriting portfolio.

(3) For firms carrying on long-term insurance business, in addition:

(a) the uncertainty of future investment returns;
(b) the effects of rapid growth or decline in the volume and nature of new business written; and
(c) the ability of firms to adjust premium rates or charges for some products.

(4) For reserving and claims risks, both general insurance business and long term insurance business firms:

(a) the frequency and size of large claims;
(b) possible outcomes relating to any disputed claims, particularly where the outcome is subject to legal proceedings;
(c) the ability of the firm to withstand catastrophic events, increases in unexpected exposures, latent claims or aggregation of claims;
(d) the possible exhaustion of reinsurance arrangements, both on a per risk and per event basis;
(e) social changes regarding an increase in the propensity to claim and to sue; and
(f) other social, economic and technological changes.

(5) For firms carrying on general insurance business:

(a) the adequacy and uncertainty of the technical claims provisions, such as outstanding claims, IBNR and claims handling expense reserves;
(b) the adequacy of other underwriting provisions, such as the provisions for unearned premium and unexpired risk reserves;
(c) the appropriateness of catastrophe models and underlying assumptions used, such as possible maximum loss (PML) factors used;
(d) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the claims reserves; and
(e) the effects of inflation.

(6) For firms carrying on long-term insurance business:

(a) the adequacy and sensitivity of the mathematical reserves to variations in future experience, including:

(i) the risk that investment returns differ from those assumed in the reserving assumptions;
(ii) the risk of variations in mortality, morbidity and persistency experience and in the exercise of options under contracts;
(iii) the rates of taxation applied, in particular where there is uncertainty over the tax treatment; and

(b) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the impact on mathematical reserves.

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Other assessments of the adequacy of capital resources

PRU 2.3.35

Firms must assess the adequacy of their financial resources and this will entail an assessment of both capital resources and liquidity resources. The stress tests and scenario analyses which a firm must carry out will assist with both assessments. However, firms may also find it helpful to approach their assessment of capital in another way.

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PRU 2.3.36

Firms may also wish to carry out an additional assessment to inform their view as to whether their capital resources are adequate. The additional assessment is to consider the extent to which the capital resources requirement (CRR) produces adequate capital for a firm's particular circumstances. In considering this, firms that are required to calculate an Enhanced Capital Requirement (ECR) may wish to note that the ECR as calculated is based upon the assumptions that a firm's business is well diversified, well managed with assets matching its liabilities and good controls, and stable with no large, unusual, or high risk transactions. Firms may find it helpful to assess the extent to which their actual business differs from these assumptions and therefore what adjustments it might be reasonable to make to the CRR or ECR to arrive at an adequate level of capital resources.

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PRU 2.3.37

Firms may find it helpful for their own assessment process if they also consider divergences from the assumptions described in PRU 2.3.36 G under the headings set out below. These are the areas which the FSA considers when forming its view of the adequacy of a firm's capital resources.
Business risk factors:

(1) market risk;
(2) securitisation risk;
(3) residual risk;
(4) concentration risk;
(5) high impact, low probability events; and
(6) cyclicality and capital planning.

Control risk factors:

(1) systems and controls.

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PRU 2.3.38

Market risk: a firm should assess its exposure to those elements of market risk that are not captured by the CRR. In doing so, firms may wish to use stress tests to determine the impact on their balance sheets of an appropriate move in market conditions. The results of this test should then be used by the firm to determine its market risk.

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PRU 2.3.39

Securitisation risk: a firm should assess its exposure to risks transferred through the securitisation of assets should those transfers fail for whatever reason. For instance, firms may contemplate two broad types of securitisation: 'embedded value securitisation' - the transfer of the value emerging from an existing block of business to bondholders; and 'risk transfer securitisation' - the purchase of protection against catastrophic risks to the insurer through the issuance of bonds whose repayment is contingent upon the non-occurrence of such risks. In either case, firms should consider the effect on their financial position of a failure of such complex arrangements to operate as anticipated or the values and risks transferred not emerging as expected.

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PRU 2.3.40

Residual risk: a firm should assess its exposure to the residual risks that may result from the partial performance or failure of risk mitigation techniques for reasons that are unconnected with their intrinsic value. This could result from (for example): ineffective documentation, a delay in payment or the inability to realise payment from a guarantor in a timely manner. Given that residual risks can always be present, firms should assess the appropriateness of their capital resources requirement against their assumptions for the risk mitigation measures that they may have in place.

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PRU 2.3.41

Concentration risk: a firm should assess and monitor its exposure to: sector, geographic, liability and asset concentrations, as well as granularity. The FSA considers that concentrations in these areas increase the firm's credit risk and where the firm identifies concentrations then they should consider the adequacy of the capital resources requirement. For instance, firms should monitor concentrations of exposure to particular reinsurers and ensure that they are aware of the implications of several of their reinsurers failing at the same time.

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PRU 2.3.42

High impact, low probability events: firms should consider stress tests and scenario analyses which are realistic - that is not too remote a possibility. However, should a firm decide to enter into a high impact, low probability transaction, the firm should satisfy itself that it has sufficient financial resources to meet its resulting financial obligation in the event the single risk materialises. For instance, a firm should not accept individual risks in circumstances where, if that single risk materialised, the claim arising would exceed the financial resources available to the firm.

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PRU 2.3.43

A firm should also consider the value of the financial obligation arising where the risks from a combination of high impact, low probability transactions that the firm has entered into materialise at the same time. A firm should ensure that in no circumstances would a combination of any consequent claims materially exceed the financial resources available to it.

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PRU 2.3.44

Cyclical and capital planning: a firm's capital resources requirement may vary as business cycles and economic conditions fluctuate over time. Firms should be aware that a deterioration in business or economic conditions could require them to raise capital or alternatively to contract their businesses at a time when market conditions are most unfavourable to raising capital. Such an effect is known as procyclicality.

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PRU 2.3.45

To reduce the impact of cyclical effects, firms should look to build-up capital levels through the course of an upturn in business and economic cycles to ensure that they have sufficient capital available to protect themselves against adverse conditions.

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PRU 2.3.46

To assess its expected capital requirements over the economic and business cycles, a firm may wish to project forward its financial position taking account of its business strategy and expected growth under a range of environmental assumptions. Projections over a three to five year period would be appropriate in most circumstances. Firms may then calculate their projected capital resources requirement and assess whether that requirement could be met from expected financial resources.

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PRU 2.3.47

Systems and controls: a firm may decide to hold additional capital resources to mitigate weaknesses in its overall control environment. Weaknesses might be indicated by the following:

(1) a failure by the firm to complete an assessment of its systems and controls in line with SYSC 3.1 (Systems and Controls) and PRU 1.4;
(2) a failure by the firm's senior management to approve its financial results; and
(3) a failure by the firm to consider an analysis of relevant internal and external information on its business and control environment.

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PRU 2.3.48

In considering any systems and control weaknesses and their effect on the adequacy of the capital resources requirement, a firm may wish to be able to demonstrate to the FSA that all the issues identified in SYSC 3.2 (Areas covered by systems and controls) have been considered; and that appropriate plans and procedures exist to deal adequately with adverse scenarios.

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Capital models

PRU 2.3.49

A firm may approach its assessment of adequate capital resources by developing a model for some or all of its business risks. Where such a model captures some of the risks identified in accordance with PRU 1.2.31 R then this will usually satisfy the requirement to perform stress tests in respect of those risks. However, the assumptions required to aggregate risks modelled and the confidence levels adopted should be considered by the firm's senior management. A firm should also consider whether any risks are not captured by the model and also the extent to which systems and control risks are not incorporated in the model.

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PRU 2.3.50

A firm should not expect the FSA to accept as adequate any particular model that it develops or that the results from the model are automatically reflected in any individual guidance given to the firm for the purpose of determining adequate capital resources. However, the FSA will take into account the results of any sound and prudent model when giving individual guidance or considering applications for a waiver under section 148 of the Act of the capital resources requirement in PRU 2.1. This section sets out the types of issues the FSA would consider before giving individual guidance or granting a waiver based on the results of a model.

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PRU 2.3.51

There is no prescribed modelling approach for how a firm develops its internal model. However, firms should be able to demonstrate:

(1) the extent of use of the internal capital model within the firm's capital management policy;
(2) that sound and appropriate risk-management techniques are employed and are embedded in the daily operations and financial resources requirements of the firm;
(3) that all material risks to which the firm is exposed have been adequately addressed by quantitative and qualitative means as appropriate;
(4) the confidence levels set and whether these are linked to the firm's corporate strategy;
(5) the time horizons set for the different types of business that the firm undertakes;
(6) the extent of historic data used and back testing carried out; and
(7) whether sufficient accuracy and validation in the internal capital model has been undertaken.

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Quantitative factors

PRU 2.3.52

The firm's model should be based on an appropriate probability of insolvency over an appropriate time period. A firm should be able to demonstrate the selected probability of insolvency and time horizon it has derived and explain why these are appropriate for its business.

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PRU 2.3.53

Good models will have as inputs (in addition to the specific examples given under the stress and scenario guidance):
For both firms carrying on general insurance business and long-term insurance business:

(1) assumed future investment returns. In particular, assumptions for future interest rates (to the extent that they impact on interest income on funds on deposit, price of and yield on fixed stock that may be purchased in future and interest income on variable interest rate assets), equity prices, dividend income, property prices, property rental income and inflation. The assumptions should take account of likely volatility and historic volatility in interest rates and asset prices;
(2) five-year predictions as to premium rates in each homogeneous category of business taking account of the effect of underwriting cycles;
(3) predictions of exposures written in each homogeneous category of business in the next five years;
(4) predictions of premium volume and expected growth under a five year business plan;
(5) expenses and commission;
(6) catastrophic events, aggregations of claims and claims affecting more than one class of business;
(7) inflation in terms of how it might affect future claims, non-settled claims that have occurred to date, future expenses, future reinsurance costs and future investment returns;
(8) reinsurance programmes in place, allowing for changing term conditions, reinstatements and loss experience features;
(9) estimates of non-recovery of reinsurance and other debtors taking account of the financial strength of each reinsurance or other counterparty; and
(10) foreign exchange movements.

For firms carrying on general insurance business in particular:

(11) frequency and severity of claims (including costs associated with claims such as professional fees) for each homogeneous category of business, allowing for any impact of future social, legal and inflationary effects (especially concerning price, earnings, medical and claims) on future claims costs;
(12) settlement patterns of claims and reinsurance recoveries for each homogeneous category of business (including occurred and future claims);
(13) unintended coverage of risks; and
(14) correlation between these risks.
For firms carrying on long-term insurance business in particular:
(15) projected claims experience for each homogeneous category of business allowing for trends in mortality/ morbidity experience;
(16) assumptions for future policyholder actions such as lapsing or surrendering a policy, ceasing to pay premiums or choosing to exercise an option under the contract; and
(17) for business where management has discretion over the level of benefits or charges, assumptions about management reactions to changes in economic conditions and consequent changes to the benefits or charges.

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PRU 2.3.54

The FSA places credence in approaches to financial models to aid the assessment of capital adequacy which involve the production of a Dynamic Financial Analysis ("DFA") model. These models transform each element in the financial projection into a statistical distribution with a range of possible outcomes, and are therefore stochastic. They would generally incorporate a suitable economic model integrated into the DFA model and linked into the generation of insurance related assumptions. The model would, as far as possible, cover all risks and all areas of business. The future time period over which projections are made should be determined with reference to the type of insurance business written, the asset profile and the insurance cycle. It may be appropriate to consider several different time periods.

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PRU 2.3.55

Due regard should also be given to the historical experience of both the firm and the wider relevant industry and market when assigning values to the above inputs.

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PRU 2.3.56

The values assigned to each of the above inputs should be derived either stochastically, by assuming the value of an item can follow an appropriate probability distribution and by selecting appropriate values at the tail of the distribution, or deterministically, using appropriate prudent assumptions. For long-term insurance business which includes options or guarantees that change in value significantly in certain economic or demographic circumstances, a stochastic approach would normally be appropriate.

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PRU 2 Annex 1

Admissible assets in insurance

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(1)

Investments that are, or amounts owed arising from the disposal of:

(a)debt securities, bonds and other money and capital market instruments; (b) loans;(c)shares and other variable yield participations;(d) units in UCITS schemes, non-UCITS retail schemes, recognised schemes and any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme);(e) land, buildings and immovable property rights;(f) an approved derivative or quasi-derivative transaction that satisfies the conditions in PRU 4.3.5 R or an approved stock lending transaction that satisfies the conditions in PRU 4.3.36 R.

(2)

Debts and claims

(a)debts owed by reinsurers, including reinsurers' shares of technical provisions;(b)deposits with and debts owed by ceding undertakings;(c) debts owed by policyholders and intermediaries arising out of direct and reinsurance operations (except where overdue for more than 3 months and other than commission prepaid to agents or intermediaries);(d) for general insurance business only, claims arising out of salvage and subrogation;(e) for long-term insurance business only, advances secured on, and not exceeding the surrender value of, long-term insurance contracts issued by the insurer;(f) tax recoveries;(g) claims against compensation funds.

(3)

Other assets

(a) tangible fixed assets, other than land and buildings;(b) cash at bank and in hand, deposits with credit institutions and any other bodies authorised to receive deposits;(c) for general insurance business only, deferred acquisition costs;(d) accrued interest and rent, other accrued income and prepayments;(e) for long-term insurance business only, reversionary interests.

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PRU 2 Annex 2

Guidance on applications for waivers relating to implicit items Implicit items under the Act

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PRU 2.2.14 R does not permit implicit items to be included in the calculation of a firm's capital resources, except subject to a waiver under section 148 of the Act. Article 27(4) of the Consolidated Life Directive states that implicit items can be included in the calculation of a firm's capital resources, within limits, provided that the supervisory authority agrees. Certain implicit items, however, are not eligible for inclusion beyond 31 December 2009 (see paragraph 5). The FSA may be prepared to grant a waiver from PRU 2.2.14 R to allow implicit items, in line with the purpose of the Consolidated Life Directive, and provided the conditions as set out in article 27(4) of the Consolidated Life Directive are met. Such a waiver would allow an implicit item to count towards the firm's capital resources available to count against its capital resources requirement (CRR) set out for realistic basis life firms in PRU 2.1.15 R and for regulatory basis only life firms in PRU 2.1.20 R. Where a firm applies for an implicit item waiver the firm may also apply for a waiver from PRU 2.2.16 R, which requires at least 50% of a firm's MCR to be covered by core tier one capital and perpetual non-cumulative preference shares. Under PRU 2.2.17 R a firm must meet the guarantee fund from the sum of the items listed at stages A, B, G and H less the sum of the items listed at stage E of PRU 2.2.14 R. PRU 2.2.17 R addresses the requirement in article 29(1) of the Consolidated Life Directive that implicit items should be excluded from capital eligible to cover the guarantee fund. Where an implicit items waiver is granted, an implicit item may potentially count as either tier one or tier two capital, but not core tier one capital. PRU 2.2.20 R requires that at least 50% of a firm's tier one capital resources must be accounted for by core tier one capital.

Under section 148 of the Act, the FSA may, on the application of a firm, grant a waiver from PRU. There are general requirements that must be met before any waiver can be granted. As explained in SUP 8, the FSA may not give a waiver unless the FSA is satisfied that:

(1)

compliance by the firm with the rules will be unduly burdensome, or would not achieve the purpose for which the rules were made; and

(2)

the waiver would not result in undue risk to persons whose interests the rules are intended to protect.

The FSA will assess compliance with the requirements in the light of all the relevant circumstances. This will include consideration of the costs incurred by compliance with a particular rule or whether a rule is framed in a way that would make compliance difficult in view of the firm's circumstances. For example, the firm may demonstrate that if an implicit item were not allowed, the firm would either have to suffer increased (and unwarranted) costs in injecting further capital resources or operate with a lower equity backing ratio (see case studies in paragraph 43). Even if a firm can demonstrate a case for an implicit item waiver, it should not assume that the FSA will grant the waiver requested, or that any waiver will be granted for the full amount of the implicit item which could be granted, as set out in this annex. The FSA will consider each application on its own merits, and taking into account all relevant circumstances, including the financial situation and business prospects of the firm.

Implicit items are economic reserves which are contained within the long-term insurance business provisions. Article 27(4) of the Consolidated Life Directive identifies three types of implicit item, in respect of: future profits, zillmerisation and hidden reserves. This annex is intended to amplify the guidance in SUP 8 relating to the granting of waivers for implicit items and to provide guidance on other aspects. Whilst this guidance applies to applications for waivers for implicit items generally, for a realistic basis life firm, to the extent that an implicit item is allocated to a with-profits fund, this guidance relates to implicit items for the purposes of determining the regulatory value of assets (see PRU 7.4.24 R).

The Consolidated Life Directive (reflecting the changes introduced by the Solvency 1 Directive) requires member states to end a firm's ability to take into account future profits implicit items by (at the latest) 31 December 2009. Until then, the maximum amount of the implicit item relating to future profits permitted under the Consolidated Life Directive is limited to 50% of the product of the estimated annual profits and the average period to run (not exceeding six years) on the policies in the portfolio. The Consolidated Life Directive further limits the maximum amount of these economic reserves that can be counted to 25% of the lesser of the available solvency margin and the required solvency margin. The changes introduced by the Solvency 1 Directive take effect for financial years beginning on or after 1 January 2004. However, the Consolidated Life Directive allows for a transitional period of five years, which runs from 20 March 2002 (the publication date of the Solvency 1 Directive), for firms to become fully compliant with these new requirements. Firms will need to consider the potential impact of these changes when engaging in future capital planning. When applying for an implicit item waiver a firm should provide the FSA with a plan showing how the firm intends to maintain its capital adequacy over the period to 31 December 2009. Firms should also be aware that the FSA will typically only grant waivers for a maximum of 12 months.

Future Profits

The future profits implicit item allows firms to take credit for margins in the mathematical reserves to the extent that these are expected to emerge from in force business. The future profit from in force business should be assessed, in the first instance, on prudent assumptions, to demonstrate that there is an 'economic reserve'. Having demonstrated that it exists, the amount should be limited to an amount calculated using a formula that takes into account the actual profit which has emerged over the last five years (see paragraph 28).

Zillmerisation

Zillmerisation is an allowance for acquisition costs that are expected, under prudent assumptions, to be recoverable from future premiums. Firms can make a direct adjustment to their reserves for zillmerisation, subject to the rules on mathematical reserves. However, where no such adjustment has been made, the FSA will consider an application for a waiver to take into account an implicit item.

Hidden reserves

Hidden reserves are reserves resulting from the underestimation of assets (other than mathematical reserves).

Process for applying for a waiver, including limits applicable when a waiver is granted

This annex sets out the procedures to be followed and the form of calculations and data which should be submitted by firms to the FSA. This guidance should also be read in conjunction with the general requirements relating to the waiver process described in SUP 8. The FSA expects that applications for waivers in respect of future profits and zillmerising will not normally be considered to pass the "not result in undue risk to persons whose interests the rules are intended to protect" test unless the relevant criteria set out in this guidance have been satisfied and an application for such a waiver may require further criteria to be satisfied for this test to be passed. As set out below, waivers in respect of either zillmerising or hidden reserves will not normally be given except in very exceptional circumstances.

Timing

A long-term insurer may apply to the FSA for a waiver in respect of implicit items. A waiver will not apply retrospectively (see SUP 8.3.6 G). Consequently, applications intended for a particular accounting reference date will normally need to be made well before that reference date. Applications by firms must be made to the FSA in writing and include the relevant details specified under SUP 8.3.3 D. Given the uncertainty in predicting the future, waivers will normally be granted for a maximum of 12 months at a time and any further applications will need to be made accordingly.

The information that will be required to enable an application to be considered as set out below, should normally include a demonstration of how the capital resources requirement is to be met, with and without the waiver. Clearly, up-to-date information may not be available before the financial year-end. In some cases information from the previous year-end's return may be used, as long as any known significant changes in the structure of the firm, or the assumptions used, have been taken into account.

If the application for a waiver is granted, when a firm submits its next return the amount of the implicit item shown should not exceed that supported by the firm's calculations as at the valuation date. In the event that the amount of the future profits item calculated by the firm based on these updated assumptions is less than the amount calculated at the time of the firm's waiver application, the lower figure should be used in the return.

An implicit item in respect of zillmerising or hidden reserves is related to the basis on which liabilities or assets have been valued. In the case of hidden reserves, as explained below, the granting of a waiver will be dependent on the overall capital resources of the firm. Waivers in respect of these implicit items will, therefore, only be made in relation to the position shown in a particular set of returns and it will be essential for firms to submit applications to the FSA well in advance of the latest date for the submission of the relevant return.

Waivers may be withdrawn by the FSA at any time (e.g. where the FSA considers the amount in respect of which a waiver has been given can no longer be justified). This may be as a result of changes in the firm's position or as a result of queries arising on scrutiny of the returns.

Information to be submitted

An application for a waiver (which includes an application for an extension to or other variation of a waiver) should be prepared using the standard application form for a waiver (see SUP 8 Annex 2D). In addition, the application should be accompanied by full supporting information to enable the FSA to arrive at a decision on the merits of the case. In particular, the application should state clearly the nature and the amounts of the implicit items that a firm wishes to count against its capital resources requirement and the treatment it proposes to adopt in counting the implicit items towards the firm's capital resources. Furthermore, the application should demonstrate that in allowing for implicit items there has been no double counting of future margins and that the basis for valuing such margins is prudent.

The FSA recognises that the assessment of the insurance technical provisions reflects the contractual obligations of the firm. Implicit items are therefore margins over and above an economic assessment in these technical provisions only. Non-contractual "constructive" obligations arising from a firm's regulatory duty to treat customers fairly e.g. regarding future terminal bonuses, are not fully captured by the technical provisions. A firm must instead be satisfied that it has sufficient capital resources at all times to meet its obligations under Principle 6. The granting of a waiver for an implicit item does not in any way detract from this requirement and a firm will need to be satisfied that this condition is still met.

As a minimum, applications for a future profits implicit item should be supported by the information contained in Forms 13, 14, 18, 19, 40, 41, 42, 48, 49, the answers to questions 1 to 12 of the abstract of the valuation report, Appendix 9.4 of IPRU(INS), the abstract of the valuation report for the realistic valuation, Appendix 9.4A of IPRU(INS) and Forms 51, 52, 53, 54 and 58. For a zillmerisation implicit item, only those items noted above forming part of the abstract valuation report will normally be needed. Applications for a waiver in respect of a hidden reserves implicit item will normally be considered only if accompanied by the information which is contained in the annual regulatory returns. In particular, the balance sheet forms, long-term insurance business revenue accounts, and abstract of the valuation report as set out in Appendices 9.1, 9.3 and 9.4 of IPRU(INS) should be provided. This is not to say that a full regulatory return must be provided in the specified format, simply that the information contained in these forms should be provided. Where appropriate, the information may be summarised.

The following supporting information relating to the calculation of the amounts claimed should be supplied for each type of implicit item in respect of which a waiver is sought:

Future profits: in addition to information related to the prospective calculation and retrospective calculation described below, the profits reported in each of the last five financial years up to the date of the most recent available valuation under rule 9.4 of IPRU(INS) which has been submitted to the FSA prior to, or together with, the application, and the amounts and nature of any exceptional items left out of account; the method used for calculating the average period to run and the results for each of the main categories of business, both before and after allowing for premature termination (where the calculation has been made in two stages); and the basis on which this allowance has been made.

Zillmerising: the categories of contracts for which an item has been calculated and the percentages of the relevant capital sum in respect of which an adjustment has been made.

Hidden reserves: particulars, with supporting evidence, of the undervaluation of assets for which recognition is sought.

Continuous monitoring by firms

Firms should take into account any material changes in financial conditions or other relevant circumstances that may have an impact on the level of future profits that can prudently be taken into account. Firms should also re-evaluate whether an application to vary an implicit item waiver should be made whenever circumstances have changed. In the event that circumstances have changed such that an amendment is appropriate, the firm must contact the FSA as quickly as possible in accordance with Principle 11. (See SUP 8.5.1 R). In this context, the FSA would expect notice of any matter that materially impacts on the firm's financial condition, or any waivers granted.

Future profits - factors to take into account when submitting calculations to support waiver applications

Where an application is made in respect of a firm which has separate with-profits funds and non-profit funds, the firm should ensure that the capital resources requirement in respect of the non-profit fund is not covered by future profits attributable to policyholders arising in the with-profits fund. Furthermore, for a realistic basis life firm the amount of the implicit item allocated to each with-profits fund should be calculated separately, as the amount allocated to each with-profits fund will be taken into consideration in the calculation of the with-profits insurance capital component (see PRU 7.4.24 R).

Firms need to assess prospective future profit (i.e. how much can reasonably be expected to arise) and compare this to maximum limits (in article 27(4) of the Consolidated Life Directive), which relate to past profits.

Future profits - prospective calculation

The application for a waiver should be supported by details of a prospective calculation of future profits arising from in-force business. The information supplied to the FSA should include a description of the method used in the calculation and of the assumptions made, together with the results arising. From 31 December 2009 at the latest, future profits implicit items will no longer be permitted under the Consolidated Life Directive. Where a firm first applies for an implicit items waiver after PRU 2.2 comes into effect, under the prospective calculation a firm should only take into consideration future profits that are expected to emerge in the period up to 31 December 2009. Implicit item waivers granted before PRU 2.2 comes into effect will continue to operate under the terms of those waivers, but an application to vary the terms of such a waiver, for example to extend the effective period, is an application for a new waiver for which a firm should usually only take into consideration future profits that are expected to emerge in the period up to 31 December 2009.

Assumptions

The assumptions made should be prudent, rather than best estimate, assumptions of future experience (that is, the prudent assumptions should allow for the fair market price for assuming that risk including associated expenses). In particular, it would not normally be considered appropriate for the projected return on any asset to be taken to be higher than the risk-free yield (that is, assessed by reference to the yield arrived at using a model of future risk free yields properly calibrated from the forward gilts market). It may also be appropriate to bring future withdrawals into account on a suitably prudent basis. For with-profits business, the assumptions for future investment returns should not capitalise future bonus loadings except where the with-profits policyholders share in risks other than the investment performance of the fund. Furthermore, the rate at which future profits are discounted should include an appropriate margin over a risk free rate of return. Calculations should also be carried out to demonstrate that the prospective calculation of the future profits arising from the in-force business supporting the application for the implicit item would be sufficient to support the amount of the implicit item under each scenario described for use in determining the resilience capital requirement - where the waiver relates to an implicit item allocated to more than one fund, this should be demonstrated separately for that element of the implicit item allocated to each fund. For an implicit item allocated to a with-profits fund, proper allowance should be made for any shareholder transfers to ensure that the implicit item is not supported by future profits which will be required to support those transfers. To the extent, if any, that future profits are dependent on the levying of explicit expense related charges (for example as in the case of unit-linked business) the documentation submitted should include a demonstration of the prudence of the assumptions made as to the level at which future charges will be levied and expenses incurred.

Other limitations on the extent to which waivers for implicit items will be granted to a realistic basis life firm

Where a waiver in respect of an implicit item is granted to a realistic basis life firm additional limits may apply by reference to a comparison of realistic excess capital and regulatory excess capital including allowance for the effect of the waiver. Where the waiver relates to an implicit item allocated partly or entirely to a with-profits fund, the waiver will contain a limitation to the effect that the regulatory excess capital for that with-profits fund, allowing for the effect of the waiver, may not exceed that fund's realistic excess capital. This limitation will apply on an ongoing basis so that, for example, in the case of an implicit item allocated to a with-profits fund, the amount of the implicit item would be limited to zero whenever the regulatory excess capital exceeded the realistic excess capital of that fund.

Other charges to future profits

To avoid double counting, no account should be taken of any future surplus arising from assets corresponding to explicit items which have been counted towards the capital resources requirement such as shareholders funds, surplus carried forward or investment reserves. Deductions should be made in the calculation of future surpluses for the impact of any other arrangements which give rise to a charge over future surplus emerging (e.g. financial reinsurance arrangements, subordinated loan capital or contingent loan agreements). Deductions should also be made to the extent that any credit has been taken for the purposes of PRU 7.4.45 R (2)(c) for the present value of future profits relating to non-profit business written in a non-profit fund. The information supplied to the FSA should identify the amount and reason for any adjustments made to the calculation of the prospective amount of future profits.

The firm should confirm to the FSA that the calculations have been properly carried out and that there are no other factors that should be taken into account.

Future profits - retrospective calculation

Overriding limit

The maximum amount of the implicit item relating to future profits permitted under the Consolidated Life Directive is 50% of the product of the estimated annual profit and the average period to run (not exceeding six years (ten years during the transitional period referred to in paragraph 5)) on the policies in the portfolio. Article 27(4) of the Consolidated Life Directive also imposes a further limit on the amount of the implicit item equal to 25% of the lower of:

(1)

the firm's capital resources; and

(2)

the higher of its base capital resources requirement for long-term insurance business and its long-term insurance capital requirement.

Once the transitional period set out in article 71(1) of the Consolidated Life Directive has expired in 2007 (see paragraph 5), the FSA will not allow a waiver for more than the amount permitted by article 27(4) of the Directive.

Definition of profits

The estimated annual profit should be taken as the average annual surplus arising in the long-term insurance fund over the last five financial years up to the date of the most recent available valuation which has been submitted to the FSA prior to, or together with, the application. For this purpose, deficiencies arising should be treated as negative surpluses. Where a firm's financial year has altered, the surplus arising in a period falling partly outside the relevant five year period should be assumed to accrue uniformly over the period in question for the purpose of estimating the profits arising within the five year period. When there has been a transfer of a block of business into the firm (or out of the firm) during the period, the impact of the transfer will need to be taken into account to reflect the remaining portfolio.

Where a firm has been carrying on long-term insurance business for less than 5 years, the total profits made during the past five years should be taken to be the aggregate of any surpluses that have arisen during the period in which long-term insurance business has been carried on less any deficiencies that may have arisen during that period. The resulting total should still be divided by five to obtain the estimated annual profit.

Exceptional items

Substantial items of an exceptional nature should be excluded from the calculation of the estimated annual profit. Such items include profits arising from an exceptional change in the value at which assets are brought into account, where this is not reflected in a similar change in the amount of the liabilities, and profits arising from a change in the overall valuation approach between one year and another. An exceptional loss (i.e. a reduction of an exceptional nature in the surplus arising) may be excluded from the calculation only to the extent that it can be set against a profit or profits up to the amount of the loss and arising from a similar cause. It is not intended, however, that any adjustment should be made for the effect on surplus of a net strengthening of reserves for costs associated with an expansion of the business or for special capital expenditure, such as the purchase of computer systems.

Double counting

The inclusion of investment income arising from the assets representing the explicit components of capital resources (as part of the estimated annual profit for the purpose of determining the future profits implicit item) would result in double-counting. If those assets were required to meet the effects of adverse developments, this would automatically result in the cessation of the contribution to profits from the associated investment income. It would clearly not be appropriate for the FSA to grant a waiver which would enable a firm to meet the capital resources requirement on the basis of counting both the capital values of the assets and the value of the income flow which they can be expected to generate.

The definition of the estimated annual profit as the surplus arising in the long-term insurance fund ensures that any contribution to surplus arising from transfers from the profit and loss account, including investment income on shareholders' assets, is not included in the estimated annual profit. Thus double-counting should not arise in respect of shareholders' assets. Double-counting may arise, however, in respect of the investment income from the assets representing the explicit components of capital resources carried within the long-term insurance fund (e.g. surplus carried forward or investment reserves), but the amount of such investment income is not separately identified in the return.

Where there is reason to suspect that the elimination of any such double-counting would reduce a firm's capital resources to close to or below the required level, or would otherwise be significant, the FSA will request this information with a view to taking account of this factor in determining the amount of the implicit item. Additional information concerning investment income should be furnished with an application for a waiver, if a firm believes that any double-counting would fall into one of the categories mentioned above.

Average period to run

The average number of years remaining to run on policies should be calculated on the basis of the weighted average of the periods for individual contracts of insurance, using as weights the actuarial present value of the benefits payable under the contracts. A separate weighted average should be calculated for each of the various categories of contract and the results combined to obtain the weighted average for the portfolio as a whole. Approximate methods of calculation, which the firm considers will give results similar to the full calculation, will be accepted. In particular, the FSA will normally accept the calculation of an average period to run for a specific category of contract on the basis of the average valuation factor for future benefits derived from data contained in the abstract of the valuation report in the regulatory returns. A firm will be asked to demonstrate the validity of the method adopted only where an abnormal distribution of the business in force gives grounds for doubt about its accuracy.

Calculations will normally be requested only for the main categories of insurance business, accounting for not less than 90% of the mathematical reserves, except where there are grounds for expecting that the exclusion of certain categories of policies under this provision might have a significant effect on the resulting average period to run. Detailed calculations will not be required where a waiver is sought in respect of a low multiple of the annual profits, well within the average period to run for the firm.

Where, for a particular category of business, a method of valuation is used which does not involve the calculation of the value of future benefits and which is significant for the firm in question, the calculation of the average period to run should be based on estimates of the value of future benefits.

Premature termination of contracts

Allowance should be made for the premature termination of contracts of insurance, based on the actual experience of the firm over the last five years, or other appropriate period, and taking into account specific features of contracts such as options which can be expected to lead to premature termination (e.g. guaranteed surrender values on income bonds written as long-term insurance contracts and option dates on flexible whole-life contracts). The adjustment should be made separately for each of the main categories of business. The use of industry-wide rates of termination will be acceptable where a firm is satisfied that this will result in sufficient allowance being made having regard to the firm's own experience. Methods of calculation that involve a degree of approximation will be permitted.

For certain types of contract, where the period left to run is most naturally defined as the term to a fixed maturity or expiry date, the allowance for premature termination should also take into account terminations resulting from death.

Overall limit

The overall average period left to run calculated as described above should be limited to a maximum of six years under article 27(4) of the Consolidated Life Directive (or a maximum of ten years during the transitional period referred to in paragraph 5) before applying it to the estimated annual profit in order to determine the maximum value of the future profits implicit item.

Definition of period to run

The definition of the period to run and the basis of the allowance for early termination should clearly be considered together. For certain types of contracts (e.g. pension contracts with a range of retirement ages or other options), there is inherent uncertainty about the likely term to run. In such circumstances any estimate for determining the amount of the future profits implicit item for which a waiver is sought should be based on prudent assumptions tending, if anything, to underestimate the average period to run.

Zillmerising

The FSA does not normally expect to grant waivers permitting implicit items due to zillmerisation except in very exceptional circumstances. Zillmerisation is an allowance for acquisition costs that are expected, under prudent assumptions, to be recoverable from future premiums. Firms can make a direct adjustment to their reserves for zillmerisation, subject to the requirements on mathematical reserves set out in PRU 7.3.43 R, and this is the usual approach. However, where no such adjustment has been made, or where the maximum adjustment has not been made in the mathematical reserves, the FSA will consider an application for an implicit item, if the amount is consistent with the amount that would have been allowed as an adjustment to mathematical reserves under PRU 7.3.43 R.

Hidden reserves

The FSA will grant waivers permitting implicit items due to hidden reserves only in very exceptional circumstances. These items relate to hidden reserves resulting from the underestimation of assets. The rules for the valuation of assets and liabilities (see PRU 1.3) which apply to assets and liabilities other than mathematical reserves are based on the valuation used by the firm for the purposes of its external accounts, with adjustments for regulatory prudence such as concentration limits for large holdings, and would not normally be expected to contain hidden reserves.

Case studies on "unduly burdensome"

Some examples of situations where the existing rules might be considered to be unduly burdensome are given below:

•

A firm writes with-profits business. The firm's investment policy is affected by its published financial position. Application of the rules without an implicit item would result in the firm adopting a lower equity backing ratio. It may be possible to demonstrate that, in the circumstances, it would be unduly burdensome to require the firm to incur costs (which might prejudice policyholders) resulting from the lower equity backing ratio, rather than take allowance for an implicit item.

•

A firm has purchased a block of in-force business, on which the future profits may be reasonably estimated. However, this asset is given no value under the rules. It may be possible to demonstrate that it is unduly burdensome for the firm to recognise the cost of acquiring the assets whilst giving no value to the asset acquired.

•

A firm has a block of in-force business, on which the future profits may be reasonably estimated. Application of the rules without an implicit item would result in a need to obtain additional capital. It may be possible to demonstrate that it is unduly burdensome, having regard to the particular circumstances of the firm, to require it to incur the costs involved in the injection of further capital rather than take allowance for an implicit item.

•

A firm has purchased matching assets for guaranteed annuity liabilities. The operation of the asset and liability valuation rules leads to statutory losses in certain circumstances in spite of good matching of assets and liabilities on a realistic basis of assessment. It may be possible to demonstrate that it is unduly burdensome to require the firm to incur the costs involved in the injection of further capital rather than take allowance for an implicit item.

Conditions which will typically be applied to implicit items waivers

Limits

Where implicit items waivers are granted, the value cannot exceed (and will normally be less than) the monetary limits described in paragraph 27, except that during the transitional period the pre-Solvency I limits will apply. In addition, time limits will apply and waivers will normally only last for 12 months.

Publicity

The FSA will publish the waiver (see SUP 8.6 and SUP 8.7). Public disclosure is standard practice unless the FSA is satisfied that publication is inappropriate or unnecessary (see section 148 of the Act). Any request that a direction not be published should be made to the FSA in writing with grounds in support, as set out in SUP 8.6.

Disclosure of a waiver will normally be required in the firm's annual returns.

31/12/2004

PRU 2 Annex 3

31/12/2004

Annex 3G

This annex provides an illustrative qualitative example of how a small firm could undertake its stress and scenario analysis without this being disproportionate to the size and complexity of its business so as to comply with PRU 1.2.35 R. For these reasons, the example does not provide any quantitative guidance as we believe this would be impractical given the diverse nature of each firm's individual circumstances.

This example is based on guidance contained in PRU 2.3. The areas discussed are not exhaustive and it is likely that in practice a firm will need to consider a range of other issues.

The scenarios that the firm generates as part of its analysis should aim to reflect the degree of risk in a variety of areas. How extreme these scenarios are will influence the ultimate level of capital required by the firm. The firm should not necessarily develop scenarios based on the current trading or economic conditions, but on possible trading or economic conditions that could occur during the next three to five years.

In addition to examining its event scenarios, a firm should also be able to meet any individual risk (however unlikely) that it has accepted (or proposes to accept through its business plan) from policyholders. It therefore should analyse its exposures and ensure that it has sufficient capital or available reinsurance to cover its largest individual risks and accumulations.

Worked example

Background

The firm used for this example is an insurer carrying on general insurance business within a large group, writing predominantly personal lines, household and motor policies of approximately £25m gross written premium. This business has a reasonable geographical spread, sourced significantly from within the United Kingdom. The firm has purchased appropriate reinsurance cover from a variety of reinsurers and has a demonstrated record of utilising this cover. Its settlement pattern for claims averages three years, however, there is a small element of the account with longer tail liability claims. The firm's investments and IT support are outsourced.

Insurance risk

The risk of incorrect or inaccurate pricing of business over the scenario period can be addressed by examining typical uncertainties within the pricing basis and the volatility of claims experience.

In examining the adequacy of its pricing, the firm establishes its underwriting and claims trend over a ten-year base period by reviewing profit and loss accounts (particularly underwriting profit). In particular it examines the following:

(i)

the volatility of losses in a particular line of business;

(ii)

whether the loss ratio exceeded 100% in any line of business; and

(iii)

whether the deferred acquisition cost (DAC) amount had been written down; e.g. whether an unexpired risk provision (URP) was necessary.

The firm also examines whether its premiums over the last ten years have been:

(i)

reasonably stable;

(ii)

responsive enough to changes in claim exposures (so that profitability is maintained);

(iii)

providing adequately for contingencies (such as major losses e.g. hail, earthquake etc);

(iv)

encouraged loss control (through the use of deductibles, no claim bonuses etc);

The firm also reviews its method of pricing. The firm considers and performs the following:

(i)

a review of acceptable rates, e.g. premiums being charged by competitors for similar products;

(ii)

an examination of whether there have been any difficulties in the past with delegated authorities in relation to pricing including the ability and experience of staff members setting or recommending premium prices;

(iii)

an examination of whether the firm has the appropriate mechanisms in place regarding premium rate changes (that is, who makes these decisions, frequency, and on what basis?); and

(iv)

a benchmark price assessment (e.g. the ability to provide adequate competitive premium rates). For example, indicative rates being determined through the use of industry statistics, competitor statistics and the firm's own analysis for all classes.

A10

Other factors the firm considers are:

(i)

changes in environment (e.g. legislation, social, economic etc);

(ii)

changes in policy conditions and deductibles; and

(iii)

impact of market segments (e.g. the effects of different claim frequencies and costs impacting the price charged).

A11

Having completed its analysis, the firm makes the following assumptions to define its underwriting risk:

(i)

claims costs. The firm assumes these are X% higher than in the premium basis;

(ii)

claims inflation. The firm assumes a X% claims inflation over the scenario period, compared to Y% in the pricing basis;

(iii)

policy expenses (fixed and variable) are X% higher than anticipated in the pricing basis;

(iv)

reinsurance charges are X% higher than anticipated in the pricing basis; and

(v)

investment income is X% lower than anticipated in the pricing basis.

As a result of the above analysis on a per risk basis, the firm considers that capital of between £X and £Y would cover the possibility of material deviations to projected results.

Allowing for catastrophes

A12

The allowance for catastrophic events within the insurance risk scenario should reflect both the severity and the frequency of these events.

A13

After considering the catastrophe reinsurance programme it may be clear that the upper limit is set at a level unlikely to be breached e.g. a 1 in 200 year event. Thus, for the purposes of the capital assessment, it would not be necessary to assume losses in excess of this retention.

A14

However, it may be determined that there is possible exhaustion of free reinstatements or of horizontal cover in total. For example, if there were a significant chance of three catastrophic losses in any one period but the reinsurance allowed only one free reinstatement, then the assessment may be to hold two retentions and the entire gross loss for the third event.

As a result of the above analysis, the firm considers it appropriate to hold capital sufficient to absorb three catastrophic losses: one European windstorm of £X, one UK flood of £Y, and one large man made explosion of £Z.

The reinsurance structure in place allows for X number of reinstatements at full premium.

Deterioration of reserves

A15

The firm considers the adequacy of its claims reserves by focussing on the liability valuation.

A16

The liability valuation may contain a range of answers that might indicate possible reserve variability. Also, the valuation will contain areas where judgement has been applied and assumptions formulated which are subjective. These areas are considered and stressed as appropriate.

A17

The firm also reviews the historic level of claims reserves and subsequent level of settlements to help determine the size of any historic levels of under and over reserving.

A18

Reinsurance arrangements are considered and the extent to which these arrangements protect against reserve deterioration is assessed.

A19

For unearned premium, where losses have yet to occur, the firm considers that the level of uncertainty is greater and considers similar factors to those relating to underwriting risk in addition to those discussed above.

As a result of the above analysis, the firm considers it appropriate to apply a X% loading to the outstanding claims provision, a Y% loading to the unearned premium provision and Z% to all other liability values. The firm considers that capital of between £X and £Y would adequately cover reserve deterioration.

Credit risk

A20

Credit risk relates to the risk of default by counterparties. The firm believes its exposure to credit risk results from financial transactions with counterparties including issuers, debtors, borrowers, brokers, policyholders, reinsurers and guarantors.

A21

When assessing credit risk the firm makes an assessment of the creditworthiness of counterparties to the assets of the firm.

A22

The assessment includes an evaluation of the credit risk associated with loans and investment portfolios; the quality of on and off balance sheet assets; the ongoing management of the loans and investment portfolios; as well as loss provisions and reserves.

A23

The firm believes its exposure to credit risk also arises due to its exposure to its reinsurers. In this regard, the firm uses the credit ratings assigned to particular counterparties as a measure of credit risk, most notably Standard & Poor's, Moody's Investors Service and AM Best's (particularly for reinsurers).

A24

When forming an opinion on credit risk the firm considers:

Reinsurance

A25

The firm's strategy is to lessen exposure to a single lead reinsurer to less than 30%, with other participants holding no more than 15%. In all cases, the panel of reinsurers all have a specified rating. The firm has no prior experience of disputes, and their working relationship with the panel may be excellent, and thus the firm does not envisage any future difficulties arising in this regard.

A26

Bond default rates could then be used to assess a likely credit risk figure for reinsurance recoveries (including IBNR recoveries).

The firm considers that capital of between £X and £Y would cover reinsurance defaults, with no additional allowance for disputes.

Overseas financial institutions and banks

A27

The firm investigates its business relationships with overseas financial institution counterparties including banks, and decides no additional allowance is required.

Quality of counterparties and trends in counterparty risk

A28

The firm assesses the level and age of debtors, focussing particularly upon unpaid premiums, especially those greater than three months old, and reviews the level and trend of contingent liabilities. For example, the firm estimates that the credit risk scenario equates to taking a 10% reduction in the asset value of debtors, based on bond default rates and age of debt.

The firm considers that capital of between £X and £Y would cover credit risk to counterparties.

Off-balance sheet transactions

A29

The firm investigates any unfunded commitments, credit derivatives, commercial or standby letters of credit. Where these exist the possibility of a loss on these instruments is considered in relation to the requirement of the credit risk scenario.

The firm considers that no additional capital is necessary.

Market risk

A30

Market risk encompasses an adverse movement in the value of the assets as a consequence of market movements such as interest rates, foreign exchange rates, equity prices, etc. which is not matched by a corresponding movement in the value of the liabilities.

A31

In examining possible market risks, the firm considers its sensitivity to market risk by evaluating the degree to which changes in interest rates, foreign exchange rates, equity prices, or other areas can adversely affect the firm's earnings or capital.

A32

The firm believes its assets and liabilities are approximately matched e.g. there is no existence of large unmatched or unhedged currency positions; short tail business is backed by cash/fixed interest assets of suitable term and long tail business with real assets e.g. shares/property. If mismatching does exist this should be allowed for within the estimate.

A33

In developing the scenario the firm estimates the effect of a X% increase in interest rates on bond values.

A34

Similarly, the firm estimates the effect on equity values of a major recession to estimate the possible reduction in the value of equity capital. Also, it uses a suitable equity index to determine the size of historical falls in equity values and indicate possible future falls.

A35

Counterparty risk might be allowed for by assuming one or several major corporate bond holding defaults.

A36

For all investments, the stability of trading revenues should be examined to determine the volatility of investment.

From the above analysis, the firm considers that capital of between £X and £Y would be appropriate to protect it against adverse movement in market risk.

Liquidity risk

A37

Liquidity risk is the potential that the firm may be unable to meet its obligations as they fall due as a consequence of having a timing mismatch. The firm considers liquidity risk relates to the risk associated with the processes of managing timing relationship between asset and liability cash flow patterns.

A38

When assessing liquidity risk, the firm considers the extent of mismatch between assets and liabilities and the amount of assets held in a highly liquid, marketable form should unexpected cashflows lead to a liquidity crunch.

A39

The price concession of liquidating assets is a prime concern when assessing liquidity risk and is built into the scenario.

A40

In examining the liquidity risk, the firm examines the following:

Marketability, quality and liquidity of assets

A41

The firm considers the assets held and makes an assessment regarding the quality and liquidity of these assets. Even though the assets matched the liabilities, residual risk remains given that timings are uncertain and there is a possibility that assets will be realised at unfavourable times. This is allowed for by assuming a 2.5% reduction in the market value of assets at realisation compared to the current market value.

The firm considers that capital of between £X and £Y would cover timing risk to counterparties.

Reliance on new business income

A42

The firm relies partially upon new business cash flows to meet current liabilities as they fall due. The firm analyses the sensitivity of future cash flow projections and new business assumptions and considers the effect of a reduced level of new business.

A43

The firm finds that it did not have immediate alternatives in place in case these expected new business cash flows were reduced. In this regard, it considers that these sources should be stressed by X%.

The firm considers that capital of between £X and £Y would cover possible effects of adjusting the asset portfolio to switch to more liquid assets.

A44

The firm also examines the volatility and cost of on- and off-balance sheet funding sources. The firm is satisfied that no concerns need to be raised and that there should not be any impact on its liquidity position.

A45

The firm believes it is well placed to manage unplanned changes in funding sources as well as react to changes in market conditions that affect its ability to quickly liquidate assets with minimal loss. The firm assesses that it has reasonable access to money markets and other sources of funding such as lines of credit.

A46

The firm has no previous problems or delays in meeting obligations (or accessing external funding).

Overall, from the above analysis, the firm considers that capital of between £X and £Y would be necessary to withstand the effects of deterioration in liquidity.

Governance Risk

A47

Governance risk relates to the risk associated with the board and/or senior management of the firm not effectively performing their respective roles.

A48

The existence and level of directors and officers insurance in place is investigated compared to known incidence of claims of this type.

A49

The firm assesses whether the current level of governance is appropriate for the firm, and the likelihood that the firm's practices may result in the board and/or senior management not adequately undertaking their roles. The cost of altering and strengthening the current board structure is considered.

A50

In this regard, the firm makes an assessment that it may be reliant on only a few senior executives, and may be exposed if they experience any misadventure.

The firm considers that capital of between £X and £Y would cover governance risk.

Strategic Risk

A51

Strategic risk arises from an inability to implement appropriate business plans and strategies, make decisions, allocate resources or adapt to changes in the business environment.

A52

The firm therefore assesses the prudence and appropriateness of its business strategy in the context of the firm's competitive and economic environment. In particular the assumptions, forecasting and projections are assessed considering the possibility of a fundamental market change due, for example, to higher numbers of competitors, changes in sales channels, new forms of insurance or changes in legislation. This review includes whether the reinsurance programme is appropriate for the risks selected by the firm and whether it adequately takes account of the underwriting and business plans of the firm generally.

A53

The firm considers the likelihood of a fundamental strategic shift too remote to include within the scenario given the maturity of the market in which they operate.

Operational risks

A54

In reviewing the operational risk exposures, the firm has examined its administration, compliance, event, fraud, governance, strategic and technological risks.

Administration

A55

The firm considers the risk of error or failure associated with the administrative aspects of the operation of its business. In this regard, the firm considers likelihood of financial loss and reputation harm due to failure or errors occurring and the likely size of these losses.

A56

None of the firm's administration is out-sourced to service providers.

A57

In undertaking the assessment, the firm considers the history of failure or error from transaction processing or control within the firm. Exception reports are produced on a quarterly basis. Past reports highlighted past administrative deficiencies. The biggest event in the past 10 years related to a situation where claim-handling staff shared access codes to the claims administration system. This resulted in an overpayment to some clients.

A58

The firm also examines the nature and extent of centralised and decentralised functions within the firm. Three branches report regularly to the central office and an appropriate system is in place to record financial information, handle complaints etc.

A59

The firm also reviews the segregation of duties between staff. It is satisfied that an adequate segregation of duties between underwriting claims and payments divisions exist in terms of acceptance, authorisation and payments. It is also satisfied that sufficient interaction between the front, middle and back offices exist in terms of financial control and risk management. For example, it is confident that its guidelines for accepting risks are adequate and that any breach would be picked up by exception reporting.

A60

The firm also investigates the level of staff expertise and training to administer its product range/services.

The firm considers that capital of between £X and £Y would cover the risk of future administration issues.

Compliance Risk

A61

The firm believes its main compliance risk relates to the risk of non-adherence to legislative and internal firm requirements.

A62

An investigation into compliance over the last 10 years finds no history of non-compliance with firm policy and control systems nor have there been any reported areas of non-compliance with legislation or other requirements.

A63

Regulatory reforms including corporate and consumer law are considered and it is assumed that expenses costs will rise as a result of developments in the next 5 years. As a result an additional X% of premium income was assumed for the expense ratio.

The firm considers that capital of between £X and £Y would cover the risk of future compliance issues.

Event risk

A64

Event risk relates to risks associated with the potential impact of significant events (e.g., financial system crisis, major change in fiscal system, natural disaster) on the operations of the firm.

A65

The definition of event risk is not intended to cover events that are directly associated with products and services offered, for example, events which may directly impact on the general insurance business.

A66

The firm concludes that no additional specific allocation is required.

Fraud Risk

A67

Fraud risk relates to the risk associated with intentional misappropriation of funds, undertaken with the objective of personal benefit at the expense of the firm.

A68

In assessing fraud risk, the firm considers the possibility of fraudulent acts occurring within the firm and the extent of controls which management has established to mitigate such acts.

A69

The firm examines fraud issues over a period of 10 years and finds one major incident where it was subject to a fraudulent activity. This involved fraudulent payments being made by a member of staff which resulted in a loss for the firm of £Xm. Based on this previous incident and allowing for improvements in controls, the company assessed a financial figure that it believes is consistent with the probability for this scenario.

The firm considers that capital of between £X and £Y would cover the risk of future fraud.

Technology Risk

A70

The firm considers the risk of error or failure associated with the technological aspects (IT systems) of its operations. Specifically, technology risk refers to both the hardware systems and the software utilised to run those systems.

A71

In relation to the firm's information systems, the firm assesses the past reliability and future functionality and believes them to be adequate. It does not have any future plans to either replace its systems or make major systems modifications.

A72

Concerning business continuity management and disaster recovery planning (and testing of plans), the firm reviews these plans regularly and tests them quarterly. A full back-up site exists with full recovery capabilities. Costs associated with utilising the site and associated business interruption insurance was estimated.

The firm considers that capital of between £X and £Y would cover technology risk.

Group risk

A73

The size of the group risk element within operational risk will depend on the ownership structure of the firm and how it is funded by the parent.

A74

The firm considers the likelihood and financial consequences of both insolvency and credit downgrading of its parent. Given the firm shares the parent's name there is a large risk of association.

A75

The firm considers it within the scope of the scenario to allow for a single downgrade of the parent's credit rating from AA to A. It does not believe the chance of insolvency great enough to allow for directly.

A76

The firm estimates the effect on its business plan and profit margins of the downgrade. It estimates the amount of business lost and the increase in marketing costs required to maintain the client base. It also allows for a change in the pricing basis to incorporate a reduced profit margin (with knock on impacts on the business volume and loss ratios).

From the above analysis, the firm considers that capital of between £X and £Y would be required to cover group risks.

Overall assessment

A77

After individually assessing each risk area, the firm considers the capital that it has estimated might be absorbed under each scenario. In aggregate the range of capital absorbed is between £X and £Y. It considers how many of these scenarios might reasonably occur within a period and the extent to which it could replace capital within that period. It takes into account scenarios which might reasonably be linked, the difficulty with which capital might be replaced if the scenarios occurred, and the changes in strategy which might need to be adopted if the scenarios occurred.

A78

The firm decides that the worst realistic combination of circumstances that might arise would absorb capital of between £A and £B.

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Export chapter as

Legal Instruments that change this Chapter Capital

PRU 3

Credit risk

PRU 3.1

Credit risk management systems and controls

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Application

PRU 3.1.1

PRU 3.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or

(2) an incoming EEA firm; or

(3) an incoming Treaty firm.

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PRU 3.1.2

PRU 3.1 applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

only in respect of the activities of the firm carried on from a branch in the United Kingdom.

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Purpose

PRU 3.1.3

This section provides guidance on how to interpret PRU 1.4 insofar as it relates to the management of credit risk.

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PRU 3.1.4

Credit risk is incurred whenever a firm is exposed to loss if another party fails to perform its financial obligations to the firm, including failing to perform them in a timely manner. It arises from both on and off balance sheet items. For contracts for traded financial instruments, for example the purchase and sale of securities or over the counter derivatives, risks may arise if the firm's counterparty does not honour its side of the contract. This constitutes counterparty risk, which can be considered a subset of credit risk. Another risk is issuer risk, which could potentially result in a firm losing the full price of a market instrument since default by the issuer could result in the value of its bonds or stocks falling to nil. In insurance firms, credit risk can arise from premium debtors, where cover under contracts of insurance may either commence before premiums become due or continue after their non-payment. Credit risk can also arise if a reinsurer fails to fulfil its financial obligation to repay a firm upon submission of a claim.

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PRU 3.1.5

Credit risk concerns the FSA in a prudential context because inadequate systems and controls for credit risk management can create a threat to the regulatory objectives of market confidence and consumer protection by:

(1) the erosion of a firm's capital due to excessive credit losses thereby threatening its viability as a going concern;
(2) an inability of a firm to meet its own obligations to depositors, policyholders or other market counterparties due to capital erosion.

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PRU 3.1.6

Appropriate systems and controls for the management of credit risk will vary with the scale, nature and complexity of the firm's activities. Therefore the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations as set out in Principle 3 to organise and control its affairs responsibly and effectively.

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Requirements

PRU 3.1.7

High level requirements for prudential systems and controls, including those for credit risk, are set out in PRU 1.4. In particular:

(1) PRU 1.4.19R (2) requires a firm to document its policy for credit risk, including its risk appetite and how it identifies, measures, monitors and controls that risk;
(2) PRU 1.4.19R (2) requires a firm to document its provisioning policy. Documentation should describe the systems and controls that it intends to use to ensure that the policy is correctly implemented;
(3) PRU 1.4.18 R requires it to establish and maintain risk management systems to identify, measure, monitor and control credit risk (in accordance with its credit risk policy), and to take reasonable steps to ensure that its systems are adequate for that purpose;
(4) In line with PRU 1.4.11 G, the ultimate responsibility for the management of credit risk should rest with a firm's governing body. Where delegation of authority occurs the governing body and relevant senior managers should approve and periodically review systems and controls to ensure that delegated duties are being performed correctly.

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Credit risk policy

PRU 3.1.8

PRU 1.4.18 R requires a firm to establish, maintain and document a business plan and risk policies. They should provide a clear indication of the amount and nature of credit risk that the firm wishes to incur. In particular, they should cover for credit risk:

(1) how, with particular reference to its activities, the firm defines and measures credit risk;
(2) the firm's business aims in incurring credit risk including:

(a) identifying the types and sources of credit risk to which the firm wishes to be exposed (and the limits on that exposure) and those to which the firm wishes not to be exposed (and how that is to be achieved, for example how exposure is to be avoided or mitigated);
(b) specifying the level of diversification required by the firm and the firm's tolerance for risk concentrations (and the limits on those exposures and concentrations); and
(c) drawing the distinction between activities where credit risk is taken in order to achieve a return (for example, lending) and activities where credit exposure arises as a consequence of pursuing some other objective (for example, the purchase of a derivative in order to mitigate market risk);

(3) how credit risk is assessed both when credit is granted or incurred and subsequently, including how the adequacy of any security and other risk mitigation techniques is assessed;
(4) the detailed limit structure for credit risk which should:

(a) address all key risk factors, including intra-group exposures and indirect exposures (for example, exposures held by related and subsidiary undertakings);
(b) be commensurate with the volume and complexity of activity;
(c) be consistent with the firm's business aims, historical performance, and its risk appetite;

(5) procedures for:

(a) approving new or additional exposures to counterparties;
(b) approving new products and activities that give rise to credit risk;
(c) regular risk position and performance reporting;
(d) limit exception reporting and approval; and
(e) identifying and dealing with problem exposures caused by the failure or the downgrading of a counterparty;

(6) the methods and assumptions used for the stress testing and scenario analysis required by PRU 1.2 (Adequacy of financial resources), including how these methods and assumptions are selected and tested;
(7) the allocation of responsibilities for implementing the credit risk policy and for monitoring adherence to, and the effectiveness of, the policy.

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Counterparty assessment

PRU 3.1.9

The firm should make a suitable assessment of the risk profile of the counterparty. The factors to be considered will vary according to both the type of credit and the counterparty being considered. This may include:

(1) the purpose of the credit, the duration of the agreement and the source of repayment;
(2) an assessment and continuous monitoring of the credit quality of the counterparty;
(3) an assessment of the claims payment record where the counterparty is a reinsurer;
(4) an assessment of the nature and amount of risk attached to the counterparty in the context of the industrial sector or geographical region or country in which it operates, as well as the potential impact on the counterparty of political, economic and market changes; and
(5) the proposed terms and conditions attached to the granting of credit, including ongoing provision of information by the counterparty, covenants attached to the facility as well as the adequacy and enforceability of collateral, security and guarantees.

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PRU 3.1.10

It is important that sound and legally enforceable documentation is in place for each agreement that gives rise to credit risk as this may be called upon in the event of a default or dispute. A firm should therefore consider whether it is appropriate for an independent legal opinion to be sought on documentation used by the firm. Documentation should normally be in place before the firm enters into a contractual obligation or releases funds.

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PRU 3.1.11

Where premium payments are made via brokers or intermediaries, the firm should describe how it monitors and controls its exposure to those brokers and intermediaries. In particular, the policy should identify whether the risk of default by the broker or intermediary is borne by the firm or the policyholder.

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PRU 3.1.12

Any variation from the usual credit policy should be documented.

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PRU 3.1.13

A firm involved in loan syndications or consortia should not rely on other parties' assessment of the credit risks involved. It will remain responsible for forming its own judgement on the appropriateness of the credit risk thereby incurred with reference to its stated credit risk policy. Similarly a firm remains responsible for assessing the credit risk associated with any insurance or reinsurance placed on its behalf by other parties.

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PRU 3.1.14

Where a credit scoring approach or other counterparty assessment process is used, the firm should periodically assess the particular approach taken in the light of past and expected future counterparty performance and ensure that any statistical process is adjusted accordingly to ensure that the business written complies with the firm's risk appetite.

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PRU 3.1.15

In assessing its contingent exposure to a counterparty, the firm should identify the amount which would be due from the counterparty if the value, index or other factor upon which that amount depends were to change.

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Credit risk measurement

PRU 3.1.16

A firm should measure its credit risk using a robust and consistent methodology which should be described in its credit risk policy; the appropriate method of measurement will depend upon the nature of the credit product provided. The firm should consider whether the measurement methodologies should be backtested and the frequency of such backtesting.

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PRU 3.1.17

A firm should also be able to measure its credit exposure across its entire portfolio or within particular categories such as exposures to particular industries, economic sectors or geographical areas.

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PRU 3.1.18

Where a firm is a member of a group that is subject to consolidated reporting, the group should be able to monitor credit exposures on a consolidated basis. See PRU 8 (Group risk).

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PRU 3.1.19

A firm should have the capability to measure its credit exposure to individual counterparties on at least a daily basis.

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Risk monitoring

PRU 3.1.20

A firm should implement an effective system for monitoring its credit risk which should be described in its credit risk policy.

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PRU 3.1.21

A firm should have a system of management reporting which provides clear, concise, timely and accurate credit risk reports to relevant functions within the firm. The reports could cover exceptions to the firm's credit risk policy, non-performing exposures and changes to the level of credit risk within the firm's credit portfolio. A firm should have procedures for taking appropriate action according to the information within the management reports, such as a review of counterparty limits, or of the overall credit policy.

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PRU 3.1.22

Individual credit facilities and overall limits should be periodically reviewed in order to check their appropriateness for both the current circumstances of the counterparty and the firm's current internal and external economic environment. The frequency of review should be appropriate to the nature of the facility.

31/12/2004

PRU 3.1.23

A firm should utilise appropriate stress testing and scenario analysis of credit exposures to examine the potential effects of economic or industry downturns, market events, changes in interest rates, changes in foreign exchange rates, changes in liquidity conditions and changes in levels of insurance losses where relevant.

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Problem exposures

PRU 3.1.24

A firm should have systematic processes for the timely identification, management and monitoring of problem exposures. These processes should be described in the credit risk policy.

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PRU 3.1.25

A firm should have adequate procedures for recovering exposures in arrears or that have had provisions made against them. A firm should allocate responsibility, either internally or externally, for its arrears management and recovery.

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Provisioning

PRU 3.1.26

PRU 1.4.19R (2) requires a firm to document its provisioning policy. A firm's provisioning policy can be maintained either as a separate document or as part of its credit risk policy.

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PRU 3.1.27

At intervals that are appropriate to the nature, scale and complexity of its activities a firm should review and update its provisioning policy and associated systems.

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PRU 3.1.28

In line with PRU 3.1.6 G, the FSA recognises that the frequency with which a firm reviews its provisioning policy once it has been established will vary from firm to firm. However, the FSA expects a firm to review at least annually whether its policy remains appropriate for the business it undertakes and the economic environment in which it operates.

31/12/2004

PRU 3.1.29

In line with PRU 1.4.12 G, the provisioning policy referred to in PRU 3.1.26 G must be approved by the firm's governing body or another appropriate body to which the firm's governing body has delegated this responsibility.

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PRU 3.1.30

In line with PRU 1.4.24 G, the FSA may request a firm to provide it with a copy of its current provisioning policy.

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PRU 3.1.31

Provisions may be general (against the whole of a given portfolio), specific (against particular exposures identified as bad or doubtful) or both. The FSA expects contingent liabilities (for example guarantees) and anticipated losses to be recognised in accordance with accepted accounting standards at the relevant time, such as those embodied in the Financial Reporting Standards issued by the Accounting Standards Board.

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Risk mitigation

PRU 3.1.32

A firm may choose to use various credit risk mitigation techniques including the taking of collateral, the use of letters of credit or guarantees, or counterparty netting agreements to manage and control their counterparty exposures. The use of such techniques does not obviate the need for thorough credit analysis and procedures. The reliance placed by a firm on risk mitigation should be described in the credit risk policy.

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PRU 3.1.33

A firm should consider the legal and financial ability of a guarantor to fulfil the guarantee if called upon to do so.

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PRU 3.1.34

A firm should monitor the validity and enforceability of its collateral arrangements.

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PRU 3.1.35

The firm should analyse carefully the protection afforded by risk mitigants such as netting agreements or credit derivatives, to ensure that any residual risk is identified, measured, monitored and controlled.

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Record keeping

PRU 3.1.36

Prudential records made under PRU 1.4.53 R should include appropriate records of:

(1) credit exposures, including aggregations of credit exposures, as appropriate, by:

(a) groups of connected counterparties;
(b) types of counterparty as defined, for example, by the nature or geographical location of the counterparty;

(2) credit decisions, including details of the decision and the facts or circumstances upon which it was made; and
(3) information relevant to assessing current counterparty and risk quality.

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PRU 3.1.37

Credit records should be retained as long as they are needed for the purpose described in PRU 3.1.36 G (subject to the minimum three year retention period). In particular, a firm should consider whether it is appropriate to retain information regarding counterparty history such as a record of credit events as well as a record indicating how credit decisions were taken.

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PRU 3.2

Credit risk in insurance

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Application

PRU 3.2.1

PRU 3.2 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 3.2.2

All of PRU 3.2, except PRU 3.2.20 R and PRU 3.2.23 R to PRU 3.2.32 G, applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

but only in respect of the activities of the firm carried on from a branch in the United Kingdom.

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PRU 3.2.3

The scope of application of PRU 3.2 is not restricted to firms that are subject to relevant EC directives. It applies, for example, to pure reinsurers.

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PRU 3.2.4

(1) This section applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.
(2) Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.

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Purpose

PRU 3.2.5

The purpose of this section is to protect policyholders and potential policyholders by setting out the requirements applicable to a firm in respect of credit risk. Credit risk is incurred whenever a firm is exposed to loss if a counterparty fails to perform its contractual obligations including failure to perform them in a timely manner. Credit risk may therefore have an impact upon a firm's ability to meet its valid claims as they fall due. Credit risk can also arise from underlying causes that have an impact upon the creditworthiness of all counterparties of a particular description or geographical location. A detailed explanation of credit risk is given at PRU 3.1.4 G.

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PRU 3.2.6

The requirements in this section address both current and contingent exposure to credit risk. PRIN, SYSC and PRU 1.4 require a firm to establish adequate internal systems and controls for exposure to credit risk. This section requires a firm to restrict its exposure to different counterparties and assets to prudent levels and to ensure that those exposures are adequately diversified. It also requires a firm to make deductions from the value of assets in respect of exposures to one asset, counterparty or group of closely related counterparties in excess of prescribed limits.

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PRU 3.2.7

This section also sets limits on the market risk arising from holding assets including securities issued or guaranteed by counterparties. This market risk is incurred whenever a firm is exposed to loss if an asset were to reduce in value or even become worthless. These market risk limits are set out in this section rather than the market risk sections in PRU because they are closely linked to the counterparty limits set out in this section.

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Overall limitation of credit risk

PRU 3.2.8

Taking into account relevant risks, a firm must restrict its counterparty exposures and asset exposures to prudent levels and ensure that those exposures are adequately diversified.

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PRU 3.2.9

(1) For the purposes of PRU 3.2, counterparty exposure is the amount a firm would lose if a counterparty were to fail to meet its obligations (either to the firm or to any other person) and if simultaneously securities issued or guaranteed by the counterparty were to become worthless.
(2) For the purposes of PRU 3.2, asset exposure is the amount a firm would lose if an asset or class of identical assets (whether or not held directly by the firm) were to become worthless.
(3) For the purposes of (1) and (2), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the counterparty failing to meet its obligations and the securities or assets becoming worthless.
(4) In determining the amount of loss in accordance with (3), the firm must take into account decreases in its capital resources that would result not only from its own direct exposures but also from:

(a) exposures held by any of its subsidiary undertakings; and
(b) synthetic exposures arising from derivatives or quasi-derivatives held or entered into by the firm or any of its subsidiary undertakings.

(5) If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (3) so much of the value of that collateral as:

(a) would be realised by the firm were it to exercise its rights in relation to the collateral; and
(b) does not exceed any of the relevant limits in PRU 3.2.22R (3).

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PRU 3.2.10

Exposure is defined in terms of loss (which is decrease in capital). It does not include exposures arising from assets that are not represented in capital or exposures which if crystallised in a loss would be offset by a consequent gain, reduction in liabilities or release of provisions, but only in so far as that gain, reduction or release would itself lead to an offsetting increase in capital resources. Examples include:

(1) exposure from the holding of assets to which the firm has attributed no value;
(2) exposure from the holding of assets that the firm has deducted from capital resources; and
(3) exposure in respect of which (and to the extent that) the firm has established a provision.

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PRU 3.2.11

In assessing the adequacy of diversification required by PRU 3.2.8 R, a firm should take into account concentrations of exposure including those arising from:

(1) different types of exposure to the same counterparty, such as deposits, loans, securities, reinsurance and derivatives;
(2) links between counterparties such that default by one might have an impact upon the creditworthiness of another; and
(3) possible changes in circumstance that would have an impact upon the creditworthiness of all counterparties of particular description or geographical location.

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PRU 3.2.12

A firm should consider how the spreading of credit risk will impact on overall counterparty quality.

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PRU 3.2.13

In assessing its exposure to a counterparty for the purpose of PRU 3.2.8 R, a firm should take into account:

(1) the period for which the exposure to that counterparty might continue;
(2) the likelihood of default during that period by the counterparty; and
(3) the loss that might result in the event of default.

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PRU 3.2.14

In assessing the loss that might result from the default of a counterparty for the purposes of PRU 3.2.8 R, a firm should take into account the circumstances that might lead to default and, in particular, how these might have an impact upon:

(1) the amount of exposure to the counterparty; and
(2) the effectiveness of any loss mitigation techniques employed by the firm.

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PRU 3.2.15

Often the same circumstances which lead to the crystallisation of contingent credit exposure, e.g. a significant claims event or a significant movement in interest, currency or asset values, also lead to an increase in the risk of default by the counterparty. In particular, if a reinsurer or derivative counterparty is being relied upon to provide protection against the consequences of an event or circumstance, a firm should take into account how that event or circumstance might have an impact upon the creditworthiness of the reinsurer or derivative counterparty.

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PRU 3.2.16

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must only rely upon a loss mitigation technique where it has good reason to believe that, taking into account the possible circumstances of default, it is likely to be effective.

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PRU 3.2.17

Loss mitigation techniques include:

(1) the right, upon default, to preferential access to some or all of the counterparty's assets, for example by exercising rights of set off, holding collateral or assets deposited back, or exercising rights under fixed or floating charges;
(2) rights against third parties upon default by the counterparty, such as guarantees, credit insurance and credit derivatives; and
(3) where the counterparty is a reinsurer, having back-up or flexible reinsurance which covers the gap in coverage left by the reinsurer's default, for example 'top and drop' reinsurance.

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PRU 3.2.18

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must not rely upon preferential access to assets unless it has taken into account appropriate professional advice as to its effectiveness.

31/12/2004

PRU 3.2.19

In particular, a firm should consider whether any preferential access to a counterparty's assets would be effective even if the counterparty were wound up by a court or other legal process or it were to be subject to any other insolvency process. A firm should also consider, where it is relying upon a right against a third party, whether, in the circumstances of the counterparty's default, the creditworthiness of that third party might be impaired.

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Large exposure limits

PRU 3.2.20

(1) A firm must take reasonable steps to limit its counterparty exposure or asset exposure to:

(a) a single counterparty;
(b) each of the counterparties within a group of closely related counterparties; and
(c) an asset or class of identical assets;

to a level where, if a total default were to occur, the firm would not become unable to meet its liabilities as they fall due.
(2) In (1), a total default occurs where:

(a) the single counterparty or all of the counterparties within the group of closely related counterparties fail to meet its or their obligations and simultaneously any securities issued or guaranteed by it or any of them become worthless; or
(b) the asset becomes worthless or all of the assets within the identical class become worthless at the same time.

(3) (1) does not apply to:

(a) a reinsurance exposure; or
(b) a counterparty exposure or asset exposure to an approved credit institution.

31/12/2004

PRU 3.2.21

In assessing its exposure to a counterparty or group of closely related counterparties, a firm should consider exposures from different sources including deposits, loans, securities and derivatives.

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Market risk and counterparty limits

PRU 3.2.22

(1) A firm must calculate the amount of the deduction from total capital required by stage L in the Table in PRU 2.2.14 R in respect of assets in excess of market risk and counterparty limits as the aggregate amount by which its counterparty exposures and asset exposures exceed the relevant limits set out in (3).
(2) Except where the contrary is expressly stated in PRU, whenever:

(a) a rule in PRU refers to assets of a firm, or of any part of a firm, or of any fund or part of a fund within a firm, which are assets of a kind referred to in any of the limits in (3); and
(b) the firm's counterparty exposure (or aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons) or asset exposure in respect of those assets exceeds any of the limits in (3);

the firm must deduct from the measure of the value of those assets (as determined in accordance with PRU 1.3) the amount by which that exposure exceeds the relevant limit in (3), or that portion of the deduction that relates to the part of the firm or fund or part of a fund in question.
(3) The limits referred to in (1) and (2) are the following, expressed as a percentage of the firm's business amount:

(a) for a counterparty exposure to an individual, unincorporated body of individuals or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related individuals or unincorporated bodies of individuals:

(i) ¼% for that part of the exposure that arises from unsecured debt;
(ii) 1% for the whole exposure (after deduction of the excess arising from the limit in (a)(i));

(b) for a counterparty exposure to an approved counterparty or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related approved counterparties:

(i) 5% for that part of the exposure not arising from short term deposits made with an approved credit institution; this limit is increased to 10% if the total of such exposures which exceed 5% is less than 40%;
(ii) 20% or £2 million if larger for the whole exposure (after deduction of the excess arising from the limit in (b)(i));

(c) for a counterparty exposure to a person, or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons, who do not fall into the categories of counterparty to whom (a) and (b) apply:

(i) 1% for that part of the exposure arising from unsecured debt; this limit is increased to 2.5% in the case of an exposure to a regulated institution;
(ii) 1% for that part of the exposure arising from shares, bonds, debt securities and other money market instruments and capital market instruments from the same counterparty that are not dealt in on a regulated market, or any beneficial interest in a collective investment scheme which is not a UCITS scheme, a non-UCITS retail scheme or a recognised scheme; the limit for that part of the exposure arising from debt securities (other than hybrid securities) issued by the same regulated institution is increased to 5%;
(iii) 5% for the whole exposure (after deduction of the excesses arising from the limits in (c)(i) and (ii));

(d) 5% for the aggregate of all counterparty exposures that fall within (c)(i) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(i);
(e) 10% for the aggregate of all counterparty exposures that fall within (c)(ii) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(ii);
(f) 5% for the aggregate of all counterparty exposures arising from unsecured loans, other than those falling within (3)(b);
(g) 3% for the asset exposure arising from all cash in hand;
(h) 10% for the asset exposure (including an exposure arising from a reversionary interest) arising from any one piece of land or building, or a number of pieces of land or buildings close enough to each other to be considered effectively as one investment.

(4) In (3) a firm's business amount means the sum of:

(a) the firm's total gross technical provisions;
(b) the amount of its other liabilities (except those included in the calculation of capital resources in accordance with PRU 2.2.14 R); and
(c) such amount as the firm may select not exceeding the amount of the firm's total capital after deductions as calculated at stage M of the calculation in PRU 2.2.14 R or, if higher:

(i) in the case of a firm carrying on general insurance business, the amount of its general insurance capital requirement; and
(ii) in the case of a firm carrying on long-term insurance business, the amount of its long-term insurance capital requirement and the amount of its resilience capital requirement.

(5) For the purpose of (4)(a), a firm's total gross technical provisions exclude technical provisions in respect of index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, the total gross technical provisions include the technical provisions in respect of that guaranteed element.
(6) In (3)(c)(ii) hybrid security means a debt security, other than an approved security, the terms of which provide, or have the effect that, the holder does not, or would not, have an unconditional entitlement to payment of interest and repayment of capital in full within 75 years of the date on which the security is being valued.

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Large exposure calculation for reinsurance exposures

PRU 3.2.23

A firm must notify the FSA in accordance with SUP 15.7 as soon as it first becomes aware that:

(1) a reinsurance exposure to a reinsurer or group of closely related reinsurers is reasonably likely to exceed 100% of its capital resources, excluding capital resources held to cover property-linked liabilities; or
(2) if (1) does not apply, that it has exceeded this limit.

31/12/2004

PRU 3.2.24

Upon notification under PRU 3.2.23 R, a firm must:

(1) demonstrate that prudent provision has been made for the reinsurance exposure in excess of the 100% limit, or explain why in the opinion of the firm no provision is required; and
(2) explain how the reinsurance exposure is being safely managed.

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PRU 3.2.25

(1) For the purposes of PRU 3.2, a reinsurance exposure is the amount of loss which a firm would suffer if a reinsurer or group of closely related reinsurers were to fail to meet its or their obligations under contracts of reinsurance reinsuring any of the firm's contracts of insurance.
(2) For the purposes of (1), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the reinsurer or group of closely related reinsurers failing to meet its or their obligations under the contracts of reinsurance.
(3) If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (2) so much of the value of that collateral as:

(a) would be realised by the firm were it to exercise its rights in relation to the collateral; and
(b) does not exceed any of the relevant limits in PRU 3.2.22R (3).

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PRU 3.2.26

A firm must, in determining its reinsurance exposures for the purposes of PRU 3.2, aggregate any reinsurance exposure where the identity of the reinsurer is not known by the firm with the highest reinsurance exposure where it does know the identity of the reinsurer.

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PRU 3.2.27

PRU 3.2.8 R provides that, taking into account relevant risks, a firm must restrict to prudent levels, and adequately diversify, its exposure to counterparties.

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PRU 3.2.28

(1) In each financial year, a firm should restrict the gross earned premiums which it pays to a reinsurer or group of closely related reinsurers to the higher of:

(a) 20% of the firm's projected gross earned premiums for that financial year; or
(b) £4 million.

(2) Compliance with this provision may be relied upon as tending to establish compliance with PRU 3.2.8 R.

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PRU 3.2.29

A firm must notify the FSA immediately in accordance with SUP 15.7 if it has exceeded, or anticipates exceeding, the limit expressed in PRU 3.2.28 E.

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PRU 3.2.30

Upon notification under PRU 3.2.29 R, a firm must explain to the FSA how, despite the excess reinsurance concentration, the credit risk is being safely managed.

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PRU 3.2.31

For the purposes of PRU 3.2.24 R and PRU 3.2.30 R, a firm's explanation of how a reinsurance exposure is being safely managed should also describe the reinsurance market in which the exposure has occurred, and the nature of the reinsurance contract. If appropriate, the firm should also provide a detailed plan and timetable explaining how the excess exposure will be reduced to an acceptable level. The explanation should be approved by a person at the firm of appropriate seniority.

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PRU 3.2.32

Where a firm can demonstrate that the arrangement does not give rise to unacceptable levels of credit risk it is unlikely that further action will be required.

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Exposures excluded from limits

PRU 3.2.33

In PRU 3.2.20 R and PRU 3.2.22 R, references to a counterparty exposure or an asset exposure do not include such an exposure arising from:

(1) a debt which is fully secured on assets whose value at least equals the amount of the debt;
(2) premium debts;
(3) advances secured on, and not exceeding the surrender value of, long-term insurance contracts of the firm;
(4) rights of salvage or subrogation;
(5) deferred acquisition costs;
(6) assets held to cover index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, PRU 3.2.20 R and PRU 3.2.22 R will nevertheless apply to assets held to cover that guaranteed element;
(7) moneys due from, or guaranteed by, a Zone A country;
(8) an approved security;
(9) a holding in a UCITS scheme.

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PRU 3.2.34

In PRU 3.2.22 R references to a counterparty exposure or an asset exposure do not include such an exposure arising from reinsurance debts and the reinsurer's share of technical provisions.

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PRU 3.2.35

If:

(1) a firm has a counterparty exposure, an asset exposure or a reinsurance exposure in respect of which it has rights over collateral; and
(2) the assets constituting that collateral would, if owned by the firm, be admissible assets;

the firm may, in determining the amount of that exposure, deduct the value of that collateral in accordance with PRU 3.2.9R (5) or, in the case of a reinsurance exposure, PRU 3.2.25R (3).

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PRU 3.2.36

If a firm has a counterparty exposure, asset exposure or reinsurance exposure the whole or any part of which is:

(1) guaranteed by a credit institution or an investment firm subject in either case to the Capital Adequacy Directive or supervision by a third country (non-EEA) supervisory authority with a Capital Adequacy Directive-equivalent regime; or
(2) adequately mitigated by a credit derivative;

the firm may, for the purposes of PRU 3.2.20 R, PRU 3.2.22 R and PRU 3.2.23 R, treat that exposure, or that part of the exposure which is so guaranteed or mitigated, as an exposure to the guarantor or derivative counterparty, rather than to the original counterparty, asset or reinsurer.

31/12/2004

PRU 3.2.37

For the purposes of PRU 3.2.36 R, references to an exposure being guaranteed include an exposure secured by a letter of credit, but to fall within PRU 3.2.36 R the guarantee or letter of credit must be direct, explicit, unconditional and irrevocable.

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PRU 3.2.38

The portion of exposure which is guaranteed or mitigated by a credit derivative is itself, as an exposure to the guarantor or derivative counterparty, subject to the limits in PRU 3.2.20 R and PRU 3.2.22 R.

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PRU 3.2.39

For the purposes of PRU 3.2.20 R and PRU 3.2.22 R, a UCITS scheme, a non-UCITS retail scheme, a recognised scheme or any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme) is to be treated as closely related to the issuer of the units in that scheme.

31/12/2004

Meaning of closely related

PRU 3.2.40

For the purposes of PRU 3.2, a group of persons is closely related if it consists solely of two or more natural or legal persons who, unless it is shown otherwise, constitute a single risk because as between any two of them one or other of the following relationships apply:

(1) one of them, directly or indirectly, has control, as defined in PRU 3.2.41 R, over the other or they are both controlled by the same third party; or
(2) there is no relationship of control as defined in PRU 3.2.41 R but they are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, the other would be likely to encounter repayment difficulties.

31/12/2004

PRU 3.2.41

For the purposes of PRU 3.2.40 R, control means the relationship between a parent undertaking and a subsidiary undertaking, as defined in Article 1 of the Consolidated Accounts Directive (83/349/EEC), or a similar relationship between any natural or legal person and an undertaking.

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PRU 3.3

Asset-related Capital Requirement

31/12/2004

Application

PRU 3.3.1

PRU 3.3 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

PRU 3.3.2

The scope of application of PRU 3.3 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.

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PRU 3.3.3

PRU 3.3 applies to a firm only in relation to its general insurance business.

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PRU 3.3.4

The adequacy of a firm's financial resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

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PRU 3.3.5

The requirements in PRU 3.3 apply to a firm on a solo basis.

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Purpose

PRU 3.3.6

PRU 2.1.9 R requires that a firm must maintain at all times capital resources equal to or in excess of its capital resources requirement. PRU 2.1.14 R provides that for a firm carrying on general insurance business the firm's capital resources requirement is the Minimum Capital Requirement.

31/12/2004

PRU 3.3.7

The FSA will use the Enhanced Capital Requirement as the benchmark for individual capital guidance for a firm carrying on general insurance business, other than a non-directive insurer. The Enhanced Capital Requirement is the sum of the asset-related capital requirement and the insurance-related capital requirement less the firm's equalisation provisions. This section sets out rules and guidance relating to the asset-related capital requirement. Rules and guidance relating to the insurance-related capital requirement are set out in PRU 7.2.

31/12/2004

PRU 3.3.8

The asset-related capital requirement is a measure of the capital that a firm should hold against the risk of loss if another party fails to perform its financial obligations to the firm or from adverse movements in the value of assets.

31/12/2004

PRU 3.3.9

The asset-related capital requirement is calculated by applying capital charge factors, expressed as a percentage, to different categories of a firm's assets. A firm should refer to PRU 1.3 which sets out how a firm must recognise and value assets and liabilities.

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Calculation of asset-related capital requirement

PRU 3.3.10

A firm must calculate its asset-related capital requirement in accordance with PRU 3.3.11 R.

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PRU 3.3.11

(1) The value of each of the firm's assets of a kind listed in the table in PRU 3.3.16 R must be multiplied by the corresponding capital charge factor.
(2) If any amount which is to be multiplied by a capital charge factor is a negative amount, that amount shall be treated as zero.
(3) No account shall be taken of:

(a) the value of any asset which is not an admissible asset;
(b) the amount (if any) by which the value of any assets exceeds the limits on exposures to a type of asset or counterparty as set out in PRU 3.2.22 R.

(4) Where a firm has entered into a derivative, then for the purposes of applying the appropriate capital charge factor as set out in PRU 3.3.16 R, it must treat the value of the derivative and the value of the asset associated with the derivative as a single asset of a type and value which most closely reflects the economic risk to the firm of the combined rights and obligations associated with the derivative and the asset associated with the derivative.
(5) The amounts resulting from multiplying each of the asset items referred to in (1) by the corresponding capital charge factor must be aggregated.
(6) The asset-related capital requirement is the amount resulting from the aggregation in (5).

31/12/2004

PRU 3.3.12

Options: some derivatives may allow a firm an option whether to buy or sell a particular asset. If an option has a positive market value (that is, in-the-money) it is likely that the firm will exercise the option in the future and the current value of the derivative and associated asset will generally acquire new characteristics and volatility (a 'synthetic asset'). For instance, an option to acquire shares at a price below their current market value is likely to be exercised and the appropriate asset-related capital requirement calculation would be to combine the cash cost of acquiring the number of shares covered by the option with the value of the derivative and apply a factor of 16% to that combined value. If an option has no market value (that is, out-of-the-money) then it is unlikely that a firm would exercise the option in which case the appropriate asset-related capital requirement charge would be zero in respect of the derivative, and the corresponding capital charge contained in Table PRU 3.3.16 R in relation to the asset associated with the derivative.

31/12/2004

PRU 3.3.13

Futures and swaps: futures or swaps may not allow the firm such an option in which case the appropriate asset-related capital charge factor to apply is the one corresponding to the asset that would be held on fulfilment of the contract and the value to which this should be applied would be the value of the asset held after the contract is fulfilled.

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PRU 3.3.14

(1) The asset-related capital charge factor for money market funds set out in the Table PRU 3.3.16 R must be applied to exposures to funds that meet the definition in (2).
(2) In PRU 3.3 an investment in a money market fund means a participation in a collective investment scheme which satisfies the following conditions:

(a) the primary investment objective of the collective investment scheme is:

(i) to maintain the net asset value of the collective investment scheme constant at par (net of earnings); or
(ii) to maintain the net asset value of the collective investment scheme at the value of investors' initial capital plus earnings;

(b) in order to pursue its primary investment objective the collective investment scheme invests exclusively in cash or in short term instruments with characteristics similar to cash or both; and
(c) the collective investment scheme undertakes to abide by the following conditions:

(i) not to allow the assets held in the collective investment scheme to exceed a weighted average maturity of 60 days;
(ii) not to invest in equity or securities with characteristics similar to equity; and
(iii) on a basis of marking-to-market at least weekly, not to permit the value of each collective investment scheme unit at any point in time to move by more than 50 basis points (0.5% of total collective investment scheme value).

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PRU 3.3.15

In PRU 3.3.16 R an insurance dependant means a regulated related undertaking which is an insurance undertaking or an insurance holding company.

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PRU 3.3.16

Table: Asset-related capital charge factors

Asset item

ECR asset-related capital charge factor

Investments

Land and Buildings

7.5%

Investments in group undertakings and participating interests

Shares in group undertakings excluding participating interests

Insurance dependants

Other

7.5%

Debt securities issued by, and loans to, group undertakings

3.5%

Participating interests

7.5%

Debt securities issued by, and loans to, undertakings in which the insurer has a participating interest

3.5%

Other financial investments

Shares and other variable-yield securities and units in unit trusts

16.0%

Money market funds

Debt securities and other fixed income securities

Approved securities

3.5%

Other

3.5%

Participation in investment pools

16.0%

Loans secured by mortgages

2.5%

Other loans

2.5%

Deposits with approved credit institutions and approved financial institutions

Other

7.5%

Deposits with ceding undertakings

3.5%

Reinsurers' share of technical provisions

Provision for unearned premium

2.5%

Claims outstanding

2.5%

Other

2.5%

Debtors

Debtors arising out of direct insurance operations

Policyholders

4.5%

Intermediaries

3.5%

Debtors arising out of reinsurance operations

2.5%

Other debtors

1.5%

Called up share capital not paid

Other Assets

Tangible assets

7.5%

Cash at bank and in hand

Other

Prepayments and accrued income

Accrued interest and rent

Deferred acquisition costs

Other prepayments and accrued income

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Export chapter as

Legal Instruments that change this Chapter Credit risk

PRU 4

Market risk

PRU 4.1

Market risk management systems and controls

31/12/2004

Application

PRU 4.1.1

PRU 4.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 4.1.2

PRU 4.1 applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

only in respect of the activities of the firm carried on from a branch in the United Kingdom.

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PRU 4.1.3

Firms should also see PRU 1.2 (PRU 1.2.40 G to PRU 1.2.55 G) and PRU 4.2.

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Purpose

PRU 4.1.4

(1) The purpose of this section is to amplify PRU 1.4 insofar as it relates to market risk.
(2) Market risk includes equity, interest rate, FX, commodity risk and interest rate risk on long-term insurance contracts. The price of financial instruments may also be influenced by other risks such as spread risk, basis risk, correlation, specific risk and volatility risk.
(3) This section does not deal with the risk management of market risk in a group context. A firm that is a member of a group should also read PRU 8.1 (Group risk systems and controls) which outlines the FSA's requirements for the risk management of market risk within a group.
(4) Appropriate systems and controls for the management of market risk will vary with the scale, nature and complexity of the firm's activities. Therefore the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations as set out in Principle 3 to organise and control its affairs responsibly and effectively.

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Requirements

PRU 4.1.5

High level requirements for prudential systems and controls, including those for market risk, are set out in PRU 1.4. In particular:

(1) PRU 1.4.19R (2) requires a firm to document its policy for market risk, including its risk appetite and how it identifies, measures, monitors and controls that risk;
(2) PRU 1.4.19R (4) requires a firm to document its asset and liability recognition policy. Documentation should describe the systems and controls that it intends to use to comply with the policy;
(3) PRU 1.4.19 R requires a firm to establish and maintain risk management systems to identify, measure, monitor and control market risk (in accordance with its market risk policy), and to take reasonable steps to establish systems adequate for that purpose;
(4) In line with PRU 1.4.11 G, the ultimate responsibility for the management of market risk should rest with a firm's governing body. Where delegation of authority occurs the governing body and relevant senior managers should approve and adequately review systems and controls to check that delegated duties are being performed correctly.

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Market risk policy

PRU 4.1.6

PRU 1.4 requires a firm to establish, maintain and document a business plan and risk policies. They should provide a clear indication of the amount and nature of market risk that the firm wishes to incur. In particular, they should cover for market risk:

(1) how, with particular reference to its activities, the firm defines and measures market risk;
(2) the firm's business aims in incurring market risk including:

(a) identifying the types and sources of market risk to which the firm wishes to be exposed (and the limits on that exposure) and those to which the firm wishes not to be exposed (and how that is to be achieved, for example how exposure is to be avoided or mitigated); and
(b) specifying the level of diversification required by the firm and the firm's tolerance for risk concentrations (and the limits on those exposures and concentrations).

31/12/2004

PRU 4.1.7

The market risk policy of a firm should be endorsed by the firm's governing body and implemented by its senior management, who should take adequate steps to disseminate the policy and train the relevant staff such that they can effectively implement the policy.

31/12/2004

PRU 4.1.8

The market risk policy of a firm should enforce the risk management and control principles and include detailed information on:

(1) the financial instruments, commodities, assets and liabilities (and mismatches between assets and liabilities) that a firm is exposed to and the limits on those exposures;
(2) the firm's investment strategy as applicable between each insurance fund;
(3) activities that are intended to hedge or mitigate market risk including mismatches caused by for example differences in the assets and liabilities and maturity mismatches; and
(4) the methods and assumptions used for measuring linear, non-linear and geared market risk including the rationale for selection, ongoing validation and testing. Methods might include stress testing and scenario analysis, option Greeks, asset/liability analysis, correlation analysis and Value-at-Risk (VaR). Exposure to non-linear or geared market risk is typically through the use of derivatives.

31/12/2004

Risk identification

PRU 4.1.9

A firm should have in place appropriate risk reporting systems that enable it to identify the types and amount of market risk to which it is, and potentially could be, exposed. The information that systems should capture may include but is not limited to:

(1) position information which may include a description of individual financial instruments and their cash flows; and
(2) market data which may consist of raw time series of market rates, index levels and prices and derived time series of benchmark yield curves, spreads, implied volatilities, historical volatilities and correlations.

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Risk measurement

PRU 4.1.10

Having identified the market risk that the firm is exposed to on at least a daily basis, a firm should be able to measure and manage that market risk on a consistent basis. This may be achieved by:

(1) regularly stress testing all or parts of the firm's portfolio to estimate potential economic losses in a range of market conditions including abnormal markets. Corporate level stress test results should be discussed regularly by risk monitors, senior management and risk takers, and should guide the firm's market risk appetite (for example, stress tests may lead to discussions on how best to unwind or hedge a position), and influence the internal capital allocation process;
(2) measuring the firm's exposure to particular categories of market risk (for example, equity, interest rate, foreign exchange and commodities) as well as across its entire portfolio of market risks;
(3) analysing the impact that new transactions or businesses may have on its market risk position on an on-going basis; and
(4) regularly backtesting realised results against internal model generated market risk measures in order to evaluate and assess its accuracy. For example, a firm should keep a database of daily risk measures such as VaR and option Greeks, and use these to back test predicted profit and loss against actual profit and loss for all trading desks and business units, and monitor the number of exceptions from agreed confidence bands.

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Valuation

PRU 4.1.11

A firm should take reasonable steps to establish systems and control procedures such that the firm complies with the requirements of PRU 1.3 (Valuation).

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PRU 4.1.12

The systems and controls referred to in PRU 4.1.11 G should include the following:

(1) the department responsible for the validation of the value of assets and liabilities should be independent of the business trading area, and should be adequately resourced by suitably qualified staff. The department should report to a suitably qualified individual, independent from the business trading area, who has sufficient authority to enforce the systems and controls policies and any alterations to valuation treatments where necessary;
(2) all valuations should be checked and validated at appropriate intervals. Where a firm has chosen not to validate all valuations on a daily basis this should be agreed by senior management;
(3) a firm should establish a review procedure to check that the valuation procedures are followed and are producing valuations in compliance with the requirements in this section. The review should be undertaken by suitably qualified staff independent of the business trading area, on a regular and ad hoc basis. In particular, this review procedure should include:

(a) the quality and appropriateness of the price sources used;
(b) valuation reserves held; and
(c) the valuation methodology employed for each product and consistent adherence to that methodology;

(4) where a valuation is disputed and the dispute cannot be resolved in a timely manner it should be reported to senior management. It should continue to be reported to senior management until agreement is reached;
(5) where a firm is marking positions to market it should take reasonable steps to establish a price source that is reliable and appropriate to enable compliance with the provisions in this section on an ongoing basis;
(6) a firm should document its policies and procedures relating to the entire valuation process. In particular, the following should be documented:

(a) the valuation methodologies employed for all product categories;
(b) details of the price sources used for each product;
(c) the procedures to be followed where a valuation is disputed;
(d) the valuation adjustment and reserving policies;
(e) the level at which a difference between a valuation assigned to an asset or liability and the valuation used for validation purposes will be reported on an exceptions basis and investigated;
(f) where a firm is using its own internal estimate to produce a valuation, it should document in detail the process followed in order to produce the valuation; and
(g) the review procedures established by a firm in relation to the requirements of this section should be adequately documented and include the rationale for the policy;

(7) a firm should maintain records which demonstrate:

(a) senior management's approval of the policies and procedures established; and
(b) management sign-off of the reviews undertaken in accordance with PRU 4.1.11 G.

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Risk monitoring

PRU 4.1.13

Risk monitoring is the operational process by which a firm monitors compliance with defined policies and procedures of the market risk policy. The firm's risk monitoring system should be independent of the employees who are responsible for exposing the firm to market risk.

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PRU 4.1.14

The market risk policy of a firm may require the production of market risk reports at various levels within the firm. These reports should provide sufficiently accurate market risk data to relevant functions within the firm, and should be timely enough to allow any appropriate remedial action to be proposed and taken, for example:

(1) at firm wide level, a market risk report may include information:

(a) summarising and commenting on the total market risk that a firm is exposed to and market risk concentrations by business unit, asset class and country;
(b) on VaR reports against risk limits by business unit, asset class and country;
(c) commenting on significant risk concentrations and market developments; and
(d) on market risk in particular legal entities and geographical regions;

(2) at the business unit level, a market risk report may include information summarising market risk by currency, trading desk, maturity or duration band, or by instrument type;
(3) at the trading desk level, a market risk report may include detailed information summarising market risk by individual trader, instrument, position, currency, or maturity or duration band; and
(4) all risk data should be readily reconcilable back to the prime books of entry with a fully documented audit trail.

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PRU 4.1.15

Risk monitoring may also include information on:

(1) the procedures for taking appropriate action in response to the information within the market risk reports;
(2) ensuring that there are controls and procedures for identifying and reporting trades and positions booked at off-market rates;
(3) the process for new product approvals;
(4) the process for dealing with situations (authorised and unauthorised) where particular market risk exposures exceed predetermined risk limits and criteria; and
(5) the periodic review of the risk monitoring process in order to check its suitability for both current market conditions and the firm's overall risk appetite.

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PRU 4.1.16

Risk monitoring should be subject to periodic independent review by suitably qualified staff.

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Risk control

PRU 4.1.17

Risk control is the independent monitoring, assessment and supervision of business units within the defined policies and procedures of the market risk policy. This may be achieved by:

(1) setting an appropriate market risk limit structure to control the firm's exposure to market risk; for example, by setting out a detailed market risk limit structure at the corporate level, the business unit level and the trading desk level which addresses all the key market risk factors and is commensurate with the volume and complexity of activity that the firm undertakes;
(2) setting limits on risks such as price or rate risk, as well as those factors arising from options such as delta, gamma, vega, rho and theta;
(3) setting limits on net and gross positions, market risk concentrations, the maximum allowable loss (also called "stop-loss"), VaR, potential risks arising from stress testing and scenario analysis, gap analysis, correlation, liquidity and volatility; and
(4) considering whether it is appropriate to set intermediate (early warning) thresholds that alert management when limits are being approached, triggering review and action where appropriate.

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Record keeping

PRU 4.1.18

High level requirements for record keeping are set out in PRU 1.4.

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PRU 4.1.19

In relation to market risk, a firm should retain appropriate prudential records of:

(1) off and on market trades in financial instruments;
(2) the nature and amounts of off and on balance sheet exposures, including aggregations of exposures;
(3) trades in financial instruments and other assets and liabilities; and
(4) methods and assumptions used in stress testing and scenario analysis and in VaR models.

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PRU 4.1.20

A firm should keep a data history to enable it to perform back testing of methods and assumptions used for stress testing and scenario analysis and for VaR models.

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PRU 4.2

Market risk in insurance

31/12/2004

Application

PRU 4.2.1

PRU 4.2 applies to an insurer, unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 4.2.2

The scope of application of PRU 4.2 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers (with the exception of PRU 4.2.53 R).

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PRU 4.2.3

(1) PRU 4.2 applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.
(2) Where a firm carries on both long-term insurance business and general insurance business, PRU 4.2 applies separately to each type of business.

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Purpose

PRU 4.2.4

This section sets out rules and guidance relating to market risk. Under PRU 7.2.20 R, a firm is required to hold admissible assets of a value sufficient to cover technical provisions . In addition, PRU 7.2.34 R sets the requirement that a firm must hold assets of appropriate amount, currency, term, safety and yield, to ensure that the cash inflows from those assets will be sufficient to meet expected cash outflows from its insurance liabilities as they are due.

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PRU 4.2.5

Market risk is the risk that as a result of market movements a firm may be exposed to fluctuations in the value of its assets, the amount of its liabilities, or the income from its assets. Sources of general market risk include movements in interest rates, equities, exchange rates and real estate prices. It is important to note that none of these sources of risk is independent of the others. For example, fluctuations in interest rates often have an impact upon equity and currency values and vice versa. Giving due consideration to these correlations is an important aspect of the prudent management of market risk.

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PRU 4.2.6

A firm may also be exposed to specific market risk, which is the risk that the market value of a specific asset, or income from that asset, may fluctuate for reasons that are not dependent on general market movements. The limits in PRU 3.2.22 R cover market risk as well as counterparty risk.

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PRU 4.2.7

PRU 4.2 addresses the impact of market risk on insurance business in the ways set out below:

(1) Any firm that carries on long-term insurance business must comply with the resilience capital requirement. This requires the firm to hold capital to cover market risk. The resilience capital requirement is dealt with in PRU 4.2.9 G to PRU 4.2.26 R.
(2) For a firm that carries on long-term insurance business, the assets that it must hold must be of a value sufficient to cover the firm's mathematical reserve requirements. PRU 7.3 contains rules and guidance as to the methods and assumptions to be used in calculating these mathematical reserves. One of these assumptions is the assumed rate of interest to be used in calculating the present value of future payments by or to a firm. PRU 4.2.28 R to PRU 4.2.48 G set out the methodology to be used in relation to long-term insurance liabilities.
(3) Firms carrying on either long-term insurance business or general insurance business are also subject to currency risk. That is, the risk that fluctuations in exchange rates may impact adversely on a firm. PRU 4.2.49 G to PRU 4.2.56 G set out the requirements a firm must meet so as to cover this risk.
(4) For a firm carrying on general insurance business, the Enhanced Capital Requirement already captures some elements of market risk. In addition, the requirements as to the assumed rate of interest used in calculating the present value of general insurance liabilities are contained in the insurance accounts rules, and these requirements are outlined in PRU 4.2.27 G.
(5) Firms carrying on long-term insurance business that have property-linked liabilities or index-linked liabilities must cover these liabilities by holding appropriate assets. PRU 4.2.57 R and PRU 4.2.58 R set out these cover requirements.

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Definitions

PRU 4.2.8

For the purposes of PRU 4.2:

(1) real estate means an interest in land, buildings or other immovable property;
(2) a significant territory is any country or territory in which more than 2.5% of a firm's long-term insurance assets (by market value), excluding assets held to cover index-linked liabilities or property-linked liabilities (see PRU 4.2.57 R and PRU 4.2.58 R), are invested; and
(3) the long term gilt yield means the annualised equivalent of the fifteen year gilt yield for the United Kingdom Government fixed-interest securities index jointly compiled by the Financial Times, the Institute of Actuaries and the Faculty of Actuaries.

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Resilience capital requirement (applicable to long-term insurance business only)

PRU 4.2.9

The resilience capital requirement forms part of the calculation of the capital resources requirement for all firms carrying on long-term insurance business. PRU 2.1.15 R to PRU 2.1.20 R set out the different elements of this calculation. These include the Minimum Capital Requirement and the Enhanced Capital Requirement. The resilience capital requirement forms part of both of these requirements (see PRU 2.1.22 R (2)and PRU 2.1.34 R (2)).

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PRU 4.2.10

(1) A firm that carries on long-term insurance business must calculate a resilience capital requirement in accordance with (2) to (5).
(2) From amongst its long-term insurance assets, the firm must identify assets which, after applying the scenarios in (3), have a value that is equal to the firm's long-term insurance liabilities under those scenarios.
(3) For the purpose of (2), the scenarios are:

(a) for those assets invested in the United Kingdom, the market risk scenario set out in PRU 4.2.16 R;
(b) subject to (c) and to PRU 4.2.26 R, for those assets invested outside of the United Kingdom, the market risk scenario set out in PRU 4.2.23 R; and
(c) where the assets in (b) are:

(i) held to cover index-linked liabilities or property-linked liabilities; or
(ii) not invested in a significant territory outside the United Kingdom;

the market risk scenario set out in PRU 4.2.16 R.
(4) The resilience capital requirement is the result of deducting B from A, where:

(a) A is the value of the assets which will produce the result described in (2); and
(b) B is the firm's long-term insurance liabilities.

(5) In calculating the value of the firm's long-term insurance liabilities under any scenario, a firm is not required to adjust the provision made under PRU 1.3.5 R in respect of a defined benefits pension scheme.

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PRU 4.2.11

The purpose of the resilience capital requirement is to cover adverse deviation from:

(1) the value of long-term insurance liabilities;
(2) the value of assets held to cover long-term insurance liabilities; and
(3) the value of assets held to cover the resilience capital requirement;

arising from the effects of market risk for equities, real estate and fixed interest securities. Other risks are not explicitly addressed by the resilience capital requirement.

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PRU 4.2.12

The amount of the resilience capital requirement calculated by the firm will depend on the firm's choice of assets held to cover the resilience capital requirement. The resilience capital requirement is held to cover not only the shortfall between the change in the value of long-term insurance liabilities and the change in the value of the assets identified to cover those liabilities, but also the change in the value of the assets identified to cover the resilience capital requirement itself.

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PRU 4.2.13

As part of the assessment of the financial resources a firm needs to hold to comply with PRU 1.2.22 R, PRU 1.2.35 R requires a firm to carry out stress tests and scenario analyses appropriate to the major sources of risk to its ability to meet its liabilities as they fall due identified in accordance with PRU 1.2.31 R. In considering the stress tests and scenario analyses relevant to the major sources of risk in the category of market risk, a firm should consider the extent to which the market risk scenarios set out in PRU 4.2.16 R to PRU 4.2.26 R are appropriate to the nature of its asset portfolio. A firm may judge that given the nature of its portfolio, a more severe stress should be adopted. The firm may also wish to bring in other asset classes, such as index-linked bonds, which should be stressed on appropriate bases, and to consider the impact of currency mismatching and any derivative positions held.

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PRU 4.2.14

The resilience capital requirement requires firms to assume different adverse market risk scenarios for equities, real estate and fixed interest securities (see PRU 4.2.16 R and PRU 4.2.23 R) to those required by PRU 7.4.68 R (UK and certain other assets) and PRU 7.4.73 R (non-UK assets) in relation to the calculation of the risk capital margin for a with-profits fund by a realistic basis life firm calculating its with-profits insurance capital component.

31/12/2004

PRU 4.2.15

Where the resilience capital requirement is affected by the presence of derivative or quasi-derivative instruments, the firm will need to consider whether the protection afforded is of suitable length or security. The firm should include the exposure to counterparties in the credit considerations of PRU 4.2.41 R both before and after calculating the resilience capital requirement.If the derivative protection is very short term the firm should consider whether issues arise under PRU 7.3.26 R (Avoidance of future valuation strain); when a derivative expires the financial position of the firm may deteriorate as a result of, for example, falls in asset values. Unless the firm holds a further reserve, the firm is likely to need to have either undertaken a fresh protection strategy or carried through the alternative to the derivative protection (such as selling equities in place of a put option) if the existing protection expires before the financial year end. If the existing derivative protection continues beyond the time of financial year end the firm must have sufficient confidence that it can renew its derivative protection or an alternative to achieve the same effect.

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Market risk scenario for assets invested in the United Kingdom

PRU 4.2.16

In PRU 4.2.10 R (3)(a), the market risk scenario for assets invested in the United Kingdom and for assets (including assets invested outside the United Kingdom) held to cover index-linked liabilities or property-linked liabilities which a firm must assume is:

(1) a fall in the market value of equities of at least 10% or, if greater, the lower of:

(a) a percentage fall in the market value of equities which would produce an earnings yield on the FTSE Actuaries All Share Index equal to 4/3 rds of the long-term gilt yield; and
(b) a fall in the market value of equities of 25% less the equity market adjustment ratio (see PRU 4.2.19 R);

(2) a fall in real estate values of 20% less the real estate market adjustment ratio for an appropriate real estate index (see PRU 4.2.21 R);
(3)

(a) the more onerous of either a fall or rise in yields on all fixed interest securities by the percentage point amount determined in (b);
(b) for the purpose of (a), the percentage point amount is equal to 20% of the long-term gilt yield.

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PRU 4.2.17

For the purposes of PRU 4.2.16 R (1) and PRU 4.2.16R (2), a firm must:

(1) assume that earnings for equities and rack rents for real estate fall by 10%, but dividends for equities remain unaltered (see PRU 4.2.36 R to PRU 4.2.38 R); and
(2) model a fall in equity and real estate markets as if the fall occurred instantaneously.

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PRU 4.2.18

An example of PRU 4.2.16 R (3) is that, where the long-term gilt yield is currently 6%, a firm would assume an increase of 20% in that yield, that is, a change of 1.2 percentage points. For the purpose of the scenario in PRU 4.2.16 R (3)(a), the firm would assume a fall or rise of 1.2 percentage points in yields on all fixed interest securities.

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Equity market adjustment ratio

PRU 4.2.19

The equity market adjustment ratio referred to in PRU 4.2.16 R (1)(b) is:

(1) if the ratio calculated in (a) and (b) lies between 75% and 100%, the result of 100% less the ratio (expressed as a percentage) of:

(a) the current value of the FTSE Actuaries All Share Index; to
(b) the average value of the FTSE Actuaries All Share Index over the preceding 90 calendar days;

(2) 0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and
(3) 25%, if the ratio calculated in (1)(a) and (b) is less than 75%.

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PRU 4.2.20

In PRU 4.2.19 R, the average value of the FTSE Actuaries All Share Index over any period of 90 calendar days means the arithmetic mean based on levels at the close of business on each of the days in that period on which the London Stock Exchange was open for trading.

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Real estate market adjustment ratio

PRU 4.2.21

The real estate market adjustment ratio for a real estate index referred to in PRU 4.2.16 R (2) and PRU 4.2.23 R (2) is:

(1) if the ratio calculated in (a) and (b) lies between 90% and 100%, the result of 100% less the ratio (expressed as a percentage) of:

(a) the current value of the real estate index; to
(b) the average value of that real estate index over the three preceding financial years;

(2) 0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and
(3) 10%, if the ratio calculated in (1)(a) and (b) is less than 90%.

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PRU 4.2.22

For the purpose of calculating the real estate market adjustment ratio in PRU 4.2.21 R, a firm should select an appropriate index of real estate values such that:

(1) the constituents of the index are reasonably representative of the nature and territory of the real estate included in the range of assets identified in accordance with PRU 4.2.10 R; and
(2) the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) of the index to be calculated over the three preceding financial years.

31/12/2004

Market risk scenario for assets invested outside the United Kingdom

PRU 4.2.23

In PRU 4.2.10 R (3)(b), subject to PRU 4.2.26 R, the market risk scenario for assets invested outside the United Kingdom (other than assets held to cover index-linked liabilities or property-linked liabilities) which a firm must assume is, for each significant territory in which assets are invested outside the United Kingdom:

(1) an appropriate fall in the market value of equities invested in that territory, which is at least equal to the percentage fall determined in PRU 4.2.16 R;
(2) a fall in real estate values in that territory of 20% less the real estate market adjustment ratio for an appropriate real estate index for that territory (see PRU 4.2.21 R); and
(3)

(a) the more onerous of either a fall or a rise in yields on all fixed interest securities by the percentage point amount determined in (b);
(b) for the purpose of (a), the percentage point amount is equal to 20% of the nearest equivalent (in respect of the method of calculation) to the long term gilt yield.

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PRU 4.2.24

For the purposes of PRU 4.2.23 R (1), an appropriate fall in the market value of equities invested in a significant territory must be determined having regard to:

(1) an appropriate equity market index for that territory; and
(2) the historical volatility of the equity market index selected in (1).

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PRU 4.2.25

For the purpose of PRU 4.2.24 R (1), an appropriate equity market index for a territory is such that:

(1) the constituents of the index are reasonably representative of the nature of the equities held in that territory which are included in the range of assets identified in accordance with PRU 4.2.10 R; and
(2) the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) and historical volatility of the index to be calculated over at least the three preceding financial years.

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PRU 4.2.26

Where the assets of a firm invested in a significant territory of a kind referred to in PRU 4.2.23 R (1), PRU 4.2.23 R (2) or PRU 4.2.23 R (3)(a) represent less than 0.5% of the firm's long-term insurance assets (excluding assets held to cover index-linked liabilities or property-linked liabilities), measured by market value, the firm may assume for those assets the market risk scenario for assets of that kind invested in the United Kingdom set out in PRU 4.2.16 R instead of the market risk scenario set out in PRU 4.2.23 R.

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Interest rates: general insurance liabilities

PRU 4.2.27

The rates of interest to be used for the calculation of the present values of general insurance liabilities are specified in the insurance accounts rules. These state that the rate of interest to be used must not exceed the lowest of:

(1) a rate prudently estimated by the firm to be earned by assets of the firm that are appropriate in magnitude and nature to cover the provisions for claims being discounted, during the period necessary for the payment of such claims;
(2) a rate justified by the performance of such assets over the preceding five years; and
(3) a rate justified by the performance of such assets during the year preceding the balance sheet date.

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Interest rates: long-term insurance liabilities

PRU 4.2.28

The rates of interest to be used for the calculation of the present value of a long-term insurance liability must not exceed 97.5% of the risk-adjusted yield (see PRU 4.2.30 R to PRU 4.2.48 G) that is expected to be achieved on:

(1) the assets allocated to cover that liability;
(2) the reinvestment of sums expected to be received from those assets (see PRU 4.2.45 R to PRU 4.2.48 G); and
(3) the investment of future premium receipts (see PRU 4.2.45 R to PRU 4.2.48 G).

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PRU 4.2.29

For the purposes of PRU 4.2.28 R, the rates of interest assumed must allow appropriately for the rates of tax that apply to the investment return on policyholder assets. The rates of tax assumed must be such that the firm's total implied liability for tax arising from the allocation of assets to liabilities is not less than the firm's actual expected liability for tax for the period in respect of which tax is to be assessed.

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Risk-adjusted yield

PRU 4.2.30

A risk-adjusted yield on an asset must be calculated by:

(1) taking the asset together with any covering derivatives, forward transactions and quasi-derivatives;
(2) assuming that the factors which affect the yield will remain unchanged after the valuation date (see PRU 4.2.33 R);
(3) valuing the asset (together with any offsetting transaction) in accordance with PRU 1.3 (Valuation);
(4) making reasonable assumptions as to whether, and if so when, any options or other rights embedded in the asset (or in any offsetting transaction) will be exercised.

31/12/2004

PRU 4.2.31

Examples of calculating a combined yield for the purposes of PRU 4.2.30 R (1):

(1) 1000 £1 shares (fully paid) of ABC plc covered by a sold future on the shares. Calculating the combined yield effectively results in a position that behaves like cash (with dividend income but no capital gain or loss on the value of the assets); and
(2) where a covering derivative contains an option exercisable by the firm (e.g. a bought put option or receiver swaption), the calculation of the risk adjusted yield should take into account the fact that on the valuation assumptions any time value will reduce over time (known as the 'wasting' nature of the time value of the option), for example, an at-the money option will expire worthless and hence the covering derivative will effectively be a negative yielding asset. There are various ways of allowing for this, for example a firm could treat the covering derivative and the asset as a single asset and calculate an internal rate of return on this combined asset. Alternatively, an explicit reserve could be set up equal and opposite to the time value of the covering derivative which would be written off in the same way as the time value on the covering derivative.

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PRU 4.2.32

The requirements in relation to offsetting transactions are set out in PRU 4.3. The options and other rights referred to in PRU 4.2.30 R (4) include those exercisable by the firm as well as those exercisable by other parties.

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PRU 4.2.33

For the purpose of PRU 4.2.30 R (2), the factors that affect yield should be ascertained as at the valuation date (that is, the date to which present values of cash flows are being calculated). All changes known to have occurred by that date must be taken into account including:

(1) changes in the rental income from real estate;
(2) changes in dividends or audited profit on equities;
(3) known or forecast changes in dividends which have been publicly announced by the issuer by the valuation date;
(4) known or forecast changes in earnings which have been publicly announced by the issuer by the valuation date;
(5) alterations in capital structure; and
(6) the value (at the most recent date at or before the valuation date for which it is known) of any determinant of the amount of any future interest or capital payment.

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PRU 4.2.34

The risk-adjusted yield is either:

(1) (for equities and real estate) a running yield (see PRU 4.2.36 R to PRU 4.2.38 R, PRU 4.2.41 R and PRU 4.2.44 R); or
(2) (for all other assets) the internal rate of return (see PRU 4.2.39 R, PRU 4.2.41 R and PRU 4.2.44 R).

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PRU 4.2.35

The risk-adjusted yield on a basket of assets is the arithmetic mean of the risk-adjusted yield on each asset weighted by that asset's market value.

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The running yield for real estate

PRU 4.2.36

For real estate the running yield is the ratio of:

(1) the rental income arising from the real estate over the previous 12 months; to
(2) the market value of the real estate.

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The running yield for equities

PRU 4.2.37

For equities the running yield is:

(1) the dividend yield, if the dividend yield is more than the earnings yield;
(2) otherwise, the sum of the dividend yield and the earnings yield, divided by two.

31/12/2004

PRU 4.2.38

For the purposes of PRU 4.2.37 R:

(1) the dividend yield is the ratio (expressed as a percentage) of dividend income over the previous 12 months from the equities for which the running yield is being calculated ("the relevant equities") to the market value of those equities;
(2) the earnings yield is the ratio (expressed as a percentage) of the audited profit (including exceptional items and extraordinary items) for the preceding financial year of the issuer of the relevant equities to the market value of those equities;
(3) the earnings yield must be calculated in accordance with whichever is most appropriate (to the issuer of the relevant equities) of United Kingdom, US or international generally accepted accounting practice.

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The internal rate of return

PRU 4.2.39

The internal rate of return on an asset is the annual rate of interest which, if used to calculate the present value of future income (before deduction of tax) and of repayments of capital (before deduction of tax) would result in the sum of those amounts being equal to the market value of the asset.

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PRU 4.2.40

The risk adjusted yield for a collective investment scheme may be determined as the weighted average of the yields on each of the investments held by the collective investment scheme.

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Credit risk

PRU 4.2.41

In both the running yield and internal rate of return the yield must be reduced to exclude that part of the yield that represents compensation for credit risk arising from the asset.

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PRU 4.2.42

An allowance for credit risk should be made for all securities except risk-free securities.

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PRU 4.2.43

Provision for credit risk for credit-rated securities may be made by reference to historic default rates of securities with a similar credit rating. However, allowance should be made both for any recent or expected changes in market conditions that may invalidate historic default rates and for the likelihood that the credit ratings on securities may deteriorate or (following such deterioration) that the issuer may default.

31/12/2004

PRU 4.2.44

Provision for credit risk for securities that are not credit-rated must be made on principles at least as prudent as those adopted for credit-rated securities.

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Investment and reinvestment

PRU 4.2.45

Except as provided in PRU 4.2.46 R:

(1) the risk-adjusted yield assumed for the investment or reinvestment of sterling sums (other than sums expected to be received within the next three years) must not exceed the lowest of:

(a) the long-term gilt yield;
(b) 3% per annum, increased by two thirds of the excess, if any, of the long-term gilt yield over 3% per annum; and
(c) 6.5% per annum; and

(2) the risk-adjusted yield assumed for the investment or reinvestment of those sterling sums expected to be received within the next three years must not exceed the risk-adjusted yield on the assets actually held adjusted linearly over the three-year period to the risk-adjusted yield determined under (1).

31/12/2004

PRU 4.2.46

For the with-profits insurance contracts of a realistic basis life firm, the risk-adjusted yield assumed for the investment or reinvestment of sums denominated in sterling must be no more than rates derived from the forward gilts yield.

31/12/2004

PRU 4.2.47

The risk-adjusted yield assumed for the investment or reinvestment of non-sterling sums must be at least as prudent as in PRU 4.2.45 R and PRU 4.2.46 R.

31/12/2004

PRU 4.2.48

The purpose of PRU 4.2.45 R to PRU 4.2.47 R is to help protect against 'reinvestment risk'. Reinvestment risk is the risk that, when the sums are actually received, interest rates (and so yields available on assets) might have fallen below current expectations.

31/12/2004

Currency risk

PRU 4.2.49

Fluctuations in foreign exchange rates may impact adversely upon a firm, including where it holds an open position in a foreign currency. This is where future cash outflows (that is liabilities) in one currency are matched by future cash inflows (that is assets) in a different currency. The circumstances in which this could arise include where the firm:

(1) has entered into contracts for the purchase or sale of foreign currency; or
(2) has entered into contracts of insurance under which claims are payable in, or determined by reference to a value or price expressed in, a foreign currency; or
(3) holds assets denominated in a foreign currency.

31/12/2004

Cover for spot and forward currency transactions

PRU 4.2.50

A firm must cover a contract providing for the purchase or sale of foreign currency by:

(1) holding the currency that must be paid by the firm under the contract; or
(2) being subject to an offsetting transaction.

31/12/2004

PRU 4.2.51

The requirements in relation to cover and offsetting transactions are set out in PRU 4.3.

31/12/2004

Currency matching of assets and liabilities

PRU 4.2.52

PRU 7.2.34 R requires a firm to cover its liabilities with assets that enable it to match, in timing, amount and currency, the cash inflows and outflows from those assets and liabilities. This permits some currency mismatching of assets and liabilities, but only if sufficient excess assets are held to cover the exposure arising from such mismatching. The level of permitted currency mismatching is also limited by PRU 4.2.53 R.

31/12/2004

PRU 4.2.53

Subject to PRU 4.2.54 R, a firm must hold admissible assets in each currency of an amount equal to at least 80% of the amount of its liabilities (excluding, for a firm that carries on general insurance business, any equalisation provision) in that currency, except where the amount of those assets does not exceed 7% of the assets in other currencies.

31/12/2004

PRU 4.2.54

PRU 4.2.53 R does not apply to:

(1) a pure reinsurer; or
(2) assets held to cover index-linked liabilities or property-linked liabilities.

31/12/2004

PRU 4.2.55

For the purpose of PRU 4.2.53 R, the currency of the liability under a contract of insurance is the currency in which the cover under the contract of insurance is expressed or, if the contract does not specify a currency:

(1) the currency of the country or territory in which the risk is situated; or
(2) if the firm on reasonable grounds so decides, the currency in which the premium payable under the contract is expressed; or
(3) if, taking into account the nature of the risks insured, the firm considers it more appropriate:

(a) the currency (based on past experience) in which it expects the claims to be paid; or
(b) if there is no past experience, the currency of the country or territory in which the firm or relevant branch is established:

(i) for contracts covering risks falling within general insurance business classes 4, 5, 6, 7, 11, 12 and 13 (producer's liability only); and
(ii) for contracts covering risks falling within any other general insurance business class where, in accordance with the nature of the risks, the firm's liabilities are liabilities to be provided in a currency other than that which would result from the application of (1) or (2); or

(4) (where a claim has been notified to the firm and the firm's liability in respect of that claim is payable in a currency other than that which would result from the application of (1), (2) or (3)) the currency in which the claim is to be paid; or
(5) (where a claim is assessed in a currency known to the firm in advance and is a currency other than that which would result from the application of (1), (2), (3) or (4)) the currency in which the claim is to be assessed.

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PRU 4.2.56

The reasonable grounds in PRU 4.2.55 R (2) include if, from the time the contract is entered into, it appears likely that a claim will be paid in the currency of the premium and not in the currency of the country in which the risk is situated.

31/12/2004

Covering linked liabilities

PRU 4.2.57

A firm must cover its property-linked liabilities with:

(1) (as closely as possible) the assets to which those liabilities are linked; or
(2) a property-linked reinsurance contract; or
(3) a combination of (1) and (2).

31/12/2004

PRU 4.2.58

A firm must cover its index-linked liabilities with:

(1) either:

(a) the assets which represent that index; or
(b) assets of appropriate security and marketability which correspond, as closely as possible, to the assets which are comprised in, or which form, the index or other reference of value to which those liabilities are linked; or

(2) a portfolio of assets whose value or yield is reasonably expected to correspond closely with the index-linked liability; or
(3) an index-linked reinsurance contract; or
(4) an index-linked approved derivative; or
(5) an index-linked approved quasi-derivative; or
(6) a combination of any of (1) to (5).

31/12/2004

PRU 4.2.59

For the purposes of PRU 4.2.57 R and PRU 4.2.58 R, a firm is not permitted to hold different assets and to cover the mismatch by holding excess assets.

31/12/2004

PRU 4.2.60

If a firm has incurred a policy liability which cannot be exactly matched by appropriate assets (for example the Limited Price Index (LPI) and Earnings Index), the firm should seek to match assets that at least cover the liabilities. For example, an LPI limited to 5% per annum may be matched by a 5% fixed interest bond or a RPI bond.

31/12/2004

PRU 4.2.61

In selecting the appropriate cover, the firm should ensure that both credit risk, and the risk that the value or yield in the assets will not, in all circumstances, match fluctuations in the relevant index, are within acceptable limits. Rules and guidance relating to credit risk are set out in PRU 3.2.

31/12/2004

PRU 4.3

Derivatives in insurance

31/12/2004

Application

PRU 4.3.1

This section applies to an insurer, unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

31/12/2004

PRU 4.3.2

The scope of application of PRU 4.3 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 4.3.3

(1) This section applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.
(2) Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.

31/12/2004

Purpose

PRU 4.3.4

PRU 2.2.12 R requires a firm to calculate its capital resources for the purpose of PRU in accordance with Table PRU 2.2.14 R, subject to the limits in PRU 2.2.16 R to PRU 2.2.26 R. Table PRU 2.2.14 R and PRU 2.2.86 R require a firm to deduct from total capital resources the value of any asset included in an insurance fund which is not an admissible asset as listed in PRU 2 Annex 1R.PRU 2 Annex 1R provides that a derivative, quasi-derivative or stock lending transaction will only be an admissible asset if it is approved. This section sets out the criteria for determining when a derivative, quasi-derivative or stock lending transaction is approved for this purpose. PRU 4.3.5 R to PRU 4.3.35 R set out the criteria for derivatives and quasi-derivatives. PRU 4.3.36 R to PRU 4.3.41 R set out the criteria for stock lending transactions.

31/12/2004

Derivatives and quasi-derivatives

PRU 4.3.5

For the purpose of PRU 2 Annex 1R (Admissible assets in insurance), a derivative or quasi-derivative is approved if:

(1) it is held for the purpose of efficient portfolio management (PRU 4.3.6 R to PRU 4.3.7 R) or reduction of investment risk (PRU 4.3.8 R to PRU 4.3.13 G);
(2) it is covered (PRU 4.3.14 R to PRU 4.3.33 G); and
(3) it is effected or issued:

(a) on or under the rules of a regulated market; or
(b) off-market with an approved counterparty and, except for a forward transaction, on approved terms and is capable of valuation (PRU 4.3.34 R to PRU 4.3.35 R).

31/12/2004

Efficient portfolio management

PRU 4.3.6

A derivative or quasi-derivative is held for the purpose of efficient portfolio management if the firm reasonably believes the derivative or quasi-derivative (either alone or together with any other covered transactions) enables the firm to achieve its investment objectives by one of the following:

(1) generating additional capital or income in one of the ways described in PRU 4.3.7 R; or
(2) reducing tax or investment cost in relation to admissible assets; or
(3) acquiring or disposing of rights in relation to admissible assets, or their equivalent, more efficiently or effectively.

31/12/2004

Generation of additional capital or income

PRU 4.3.7

The generation of additional capital or income falls within PRU 4.3.6 R (1) where it arises from:

(1) taking advantage of pricing imperfections in relation to the acquisition and disposal (or disposal and acquisition) of rights in relation to assets the same as, or equivalent to, admissible assets; or
(2) receiving a premium for selling a covered call option or its equivalent, the underlying of which is an admissible asset, even if that additional capital or income is obtained at the expense of surrendering the chance of greater capital or income.

31/12/2004

Reduction of investment risk

PRU 4.3.8

A derivative or quasi-derivative is held for the purpose of reducing investment risk if the derivative or quasi-derivative (either alone or together with other fully covered transactions) reduces any aspect of investment risk without significantly increasing any other aspect of that risk.

31/12/2004

Significant increase in risk

PRU 4.3.9

For the purposes of PRU 4.3.8 R, an increase in risk from a derivative or quasi-derivative is significant unless:

(1) relative to any reduction in investment risk it is both small and reasonable; or
(2) the risk is remote.

31/12/2004

PRU 4.3.10

PRU 4.3.8 R does not require that a derivative or quasi-derivative has no possible adverse consequences. Often a derivative or quasi-derivative is effected to protect against a severe adverse consequence that only arises in one circumstance. In all other circumstances it may itself lead to adverse consequences, even if only because it expires worthless resulting in the loss of the purchase price. Conversely a derivative or quasi-derivative may reduce risk in a wide range of circumstances but lead to adverse consequences when a particular circumstance arises, e.g. the default of the counterparty. Only rarely does a derivative or quasi-derivative give rise to no adverse consequences in any circumstances. The test is merely that the increase in risk should not be significant, that is it should be both small and reasonable, or the risk should be remote.

31/12/2004

PRU 4.3.11

Firms are reminded that PRU 3.2 (Credit risk in insurance) sets out the different types of loss mitigation techniques.

31/12/2004

Investment risk

PRU 4.3.12

For the purposes of PRU 4.3.8 R, investment risk is the risk that the assets held by a firm:

(1) (where they are admissible assets held by the firm to cover its technical provisions) might not be:

(a) of a value at least equal to the amount of those technical provisions as required by PRU 7.2.20 R; or
(b) of appropriate safety, yield and marketability as required by PRU 7.2.34R (1)(a); or
(c) of an appropriate currency match as required by PRU 4.2.53 R;

(2) (where they are held to cover index-linked liabilities) might not be appropriate cover for those liabilities as required by PRU 4.2.58 R; and
(3) (where they are held to cover property-linked liabilities) might not be appropriately selected in accordance with contractual and constructive liabilities as required by PRU 7.6.36 R and appropriate cover for those liabilities as required by PRU 4.2.57 R.

31/12/2004

PRU 4.3.13

In assessing whether investment risk is reduced, the impact of a transaction on both the assets and liabilities should be considered. In particular, where the amount of liabilities depends upon the fluctuations in an index or other factor, investment risk is reduced where assets whose value fluctuates in the same way match those liabilities. In appropriate circumstances this may include:

(1) a derivative or quasi-derivative that is linked to the same index as the liabilities from the index-linked contracts; and
(2) a derivative or quasi-derivative whose value depends upon the factors which give rise to general insurance claims, e.g. a weather quasi-derivative.

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Cover

PRU 4.3.14

A firm must cover an obligation to transfer assets or pay monetary amounts that arises from:

(1) a derivative or quasi-derivative; or
(2) a contract (other than a contract of insurance) for the purchase, sale or exchange of assets.

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PRU 4.3.15

An obligation to transfer assets or pay monetary amounts (see PRU 4.3.14 R) must be covered:

(1) by assets, a liability or a provision (see PRU 4.3.16 R to PRU 4.3.24 R); or
(2) by an offsetting transaction (see PRU 4.3.25 R to PRU 4.3.27 R).

31/12/2004

PRU 4.3.16

An obligation to transfer assets (other than money) or to pay monetary amounts based on the value of, or income from, assets is covered if the firm holds:

(1) those assets; or
(2) in the case of an index or basket of assets, a reasonable approximation to those assets.

31/12/2004

PRU 4.3.17

An obligation to pay a monetary amount (whether or not falling in PRU 4.3.16 R) is covered if:

(1) the firm holds admissible assets that are sufficient in value so that the firm reasonably believes that following reasonably foreseeable adverse variations (relying solely on cashflows from, or from realising, those assets) it could pay the monetary amount in the right currency when it falls due; or
(2) the obligation to pay the monetary amount is offset by a liability. An obligation is offset by a liability where an increase in the amount of that obligation would be offset by a decrease in the amount of that liability; or
(3) a provision at least equal to the value of the assets in (1) is implicitly or explicitly set up. A provision is implicitly set up to the extent that the obligation to pay the monetary amount is recognised under PRU 1.3 (Valuation) either by offset against an asset or as a separate liability. A provision is explicitly set up if it is in addition to an implicit provision.

31/12/2004

PRU 4.3.18

A firm must implicitly or explicitly set up a provision equal to the value of the assets or offsetting transactions held to cover a non-approved derivative or quasi-derivative transaction.

31/12/2004

PRU 4.3.19

Where a firm partially covers a derivative (or other contract falling within PRU 4.3.14 R (1) and PRU 4.3.14R (2)), the firm may split the derivative into a covered portion and an uncovered portion. The portion of the derivative that is covered (after taking into account the requirement to cover reasonably foreseeable adverse variations in PRU 4.3.17 R (1)) is an approved derivative, provided it also meets the requirements in PRU 4.3.5 R (1) and PRU 4.3.5 R (3); the uncovered portion is not an approved derivative.

31/12/2004

PRU 4.3.20

Exposure to a transaction includes exposure that arises from a right at the firm's (or its subsidiary undertaking's) option to dispose of assets.

31/12/2004

PRU 4.3.21

Cover serves three purposes. First, it protects against exposure to loss from the transaction which is being covered. The value of the cover increases (or if the cover is a liability the amount of that liability decreases) to match any increase in obligations under the transaction.

31/12/2004

PRU 4.3.22

The second purpose of cover is that it prevents excessive gearing in the investment portfolio by the use of options and their equivalent. A firm is required to cover all obligations under an admissible transaction including obligations that would arise only at the option of the firm, e.g. the liability to pay the exercise price under a bought option.

31/12/2004

PRU 4.3.23

The third purpose of cover is that it protects against the risk that the firm may not be able to deliver assets (including money in any currency) of the right type when the obligation falls due under the transaction. An obligation to deliver assets is covered only if the firm holds those assets or has entered into an offsetting transaction that would deliver those assets when needed. An obligation to pay money is offset only if the firm holds cash in the right currency, its equivalent or assets that could reliably be converted into cash in the right currency.

31/12/2004

PRU 4.3.24

Cover used for one transaction must not be used for cover in respect of another transaction or any other agreement to acquire, or dispose of, assets or to pay or repay money.

31/12/2004

Offsetting transactions

PRU 4.3.25

An offsetting transaction means:

(1) an approved derivative, approved stock lending transaction or an approved quasi-derivative; or
(2) a covered transaction with an approved counterparty for the purchase of assets.

31/12/2004

PRU 4.3.26

A transaction offsets an obligation to transfer assets away from the firm only if it provides for the transfer to the firm of those assets, or their value, at the time, or before, the obligation falls due.

31/12/2004

PRU 4.3.27

A transaction offsets an obligation to pay a monetary amount only if it provides for that monetary amount to be paid to the firm at or before the earliest date on which the obligation might fall due.

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Lending and borrowing assets

PRU 4.3.28

Assets that have been lent by the firm are not available for cover, unless:

(1) they are non-monetary assets that have been lent under a transaction that fulfils the conditions in PRU 4.3.36 R; and
(2) the firm reasonably believes the assets to be obtainable (by return or re-acquisition) in time to meet the obligation for which cover is required.

31/12/2004

PRU 4.3.29

Assets that have been borrowed by the firm are not available for cover except as allowed by PRU 4.3.30 R.

31/12/2004

PRU 4.3.30

Borrowed money may be used as cover only where:

(1) the money has been advanced or an approved credit institution has committed itself to advance the money; and
(2) the borrowing is or would be covered.

31/12/2004

PRU 4.3.31

PRU 4.3.30 R in effect allows borrowings to be used to bridge the gap between an obligation under a transaction that might fall due at one date and cash or its equivalent that would only become due at a later date. Borrowings may not be used to gear the investment portfolio.

31/12/2004

Examples of cover requirements

PRU 4.3.32

Examples of cover by assets for the purposes of PRU 4.3.16 R:

(1) a bought put option (or a sold call option) on 1000 £1 shares (fully paid) of ABC plc is covered by an existing holding in the fund of 1000 £1 shares (fully paid) of ABC plc;
(2) a bought call option (or sold put option) on 1000 ordinary £1 shares (fully paid) of ABC plc is covered by cash (or its equivalent) which is sufficient in amount to meet the purchase price of the shares on exercise of the option;
(3) a bought or sold contract for differences on short-dated sterling is covered by cash (or its equivalent), the value of which together at least match the notional principal of the contract. For example, a LIFFE short sterling contract, or a successive series of such contracts, is covered by £500,000; and
(4) a sold future on the FT-SE 100 index is covered by holdings of equities, which satisfy the reasonable approximation test for cover in PRU 4.3.16 R (2) in relation to that future, and the values of which together at least match the current mark to market valuation of the future. For example, if the multiplier per full point is £10, and if the eventual obligation under the future is currently 2800, the valuation of the futures position is 2800 x £10 = £28,000.

31/12/2004

PRU 4.3.33

Examples of cover by offsetting transactions for the purpose of PRU 4.3.25 R would include a bought future which is guaranteed to deliver to the firm at the relevant time sufficient assets to cover liabilities under a sold call option.

31/12/2004

Over the counter transactions

PRU 4.3.34

For the purpose of PRU 4.3.5 R (3)(b), a transaction is on approved terms only if the counterparty has agreed to enter into a further transaction to close out the first transaction at a price based on current market conditions.

31/12/2004

PRU 4.3.35

A transaction is capable of valuation only if the firm, throughout the life of the transaction, will be able to value it with reasonable accuracy on a reliable basis reflecting an up-to-date mark-to-market value.

31/12/2004

Stock lending

PRU 4.3.36

For the purposes of PRU 2 Annex 1R (Admissible assets in insurance), a stock lending transaction is approved if:

(1) the assets lent are admissible assets;
(2) the counterparty is an authorised person or an approved counterparty; and
(3) adequate and sufficiently immediate collateral (PRU 4.3.38 R to PRU 4.3.41 R) is obtained to secure the obligation of the counterparty.

31/12/2004
Future version of PRU 4.3.36 after 29/09/2005

PRU 4.3.37

PRU 4.3.36 R refers only to stock lending transactions where the firm is the lender. There are no special rules for a transaction under which the firm borrows securities.

31/12/2004

Collateral

PRU 4.3.38

For the purposes of PRU 4.3.36 R (3), collateral is adequate only if it:

(1) is transferred to the firm or its agent;
(2) is, at the time of the transfer, at least equal in value to the value of the securities transferred, or consideration provided, by the firm; and
(3) is of adequate quality.

31/12/2004

PRU 4.3.39

For the purposes of assessing adequate quality in PRU 4.3.38 R (3), reference should be made to the criteria for credit risk loss mitigation set out in PRU 3.2.16 R. The valuation rules in PRU 1.3 apply for the purpose of determining the value of both collateral received and the securities transferred. In addition, collateral that is not an admissible asset does not have a value (see PRU 2 Ann 1).

31/12/2004

PRU 4.3.40

For the purposes of PRU 4.3.36 R (3), collateral is sufficiently immediate only if:

(1) it is transferred before, or at the same time as, the transfer of the securities by the firm; or
(2) it will be transferred, at latest, by the close of business on the day of the transfer.

31/12/2004

PRU 4.3.41

Collateral continues to be adequate only if its value is at all times at least equal to the value of the securities transferred by the firm. This will be satisfied in respect of collateral the validity of which is about to expire or has expired where sufficient collateral will again be transferred at the latest by the close of business on the day of expiry.

31/12/2004

Export chapter as

Legal Instruments that change this Chapter Market risk

PRU 5

Liquidity

PRU 5.1

Liquidity risk systems and controls

31/12/2004

Application

PRU 5.1.1

PRU 5.1 applies to an insurer unless PRU 5.1.8 R applies.

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PRU 5.1.2

All of PRU 5.1, except PRU 5.1.17 G, PRU 5.1.27 G, PRU 5.1.58 G to PRU 5.1.60 G, PRU 5.1.61 E, PRU 5.1.62 G, PRU 5.1.85 G, PRU 5.1.86 E, and PRU 5.1.87 G to PRU 5.1.91 G, applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

but only in respect of the activities of the firm carried on from a branch in the United Kingdom.

31/12/2004

PRU 5.1.3

Subject to PRU 5.1.5 R, PRU 5.1.6 R and PRU 5.1.8 R, the following provisions of PRU 5.1 apply to a firm described in PRU 5.1.4 R:

31/12/2004

PRU 5.1.4

The firms referred to in PRU 5.1.3 R are:

(1) a building society;
(2) a bank or an own account dealer (other than a venture capital firm) that is a UK firm;
(3) an incoming EEA firm which:

(a) is a full BCD credit institution; and
(b) has a branch in the United Kingdom;

(4) an overseas firm which is a bank or an own account dealer (other than a venture capital firm) but which is not:

(a) an incoming EEA firm; or
(b) a lead-regulated firm;

(5) an overseas firm which:

(a) is a bank;
(b) is a lead-regulated firm;
(c) is not an incoming EEA firm; and
(d) has a branch in the United Kingdom.

31/12/2004

PRU 5.1.5

For a firm described in PRU 5.1.4R (3) or PRU 5.1.4R (5), PRU 5.1 applies only with respect to the branch.

31/12/2004

PRU 5.1.6

This section applies to an incoming EEA firm only to the extent that the relevant matter is not reserved by the relevant Single Market Directive to the firm's Home State regulator.

31/12/2004

PRU 5.1.7

If a firm carries on:

(1) long-term insurance business; and
(2) general insurance business;

this section applies separately to each type of business.

31/12/2004

PRU 5.1.8

This section does not apply to:

(1) a non-directive friendly society; or
(2) a UCITS qualifier; or
(3) an ICVC; or
(4) an incoming EEA firm (unless PRU 5.1.4 R applies); or
(5) an incoming Treaty firm.

31/12/2004

PRU 5.1.9

For the purposes of this section, the guidance in PRU 1.4.14 G to PRU 1.4.16 G applies to a firm described in PRU 5.1.4 R.

31/12/2004

Purpose

PRU 5.1.10

The purpose of this section is to amplify parts of PRU in their application to liquidity risk and, in so doing, to suggest minimum standards for systems and controls in respect of that risk. The main relevant part, PRU 1.4, itself amplifies Principle 3 (Management and control) and SYSC (Senior management arrangements, Systems and Controls).

31/12/2004

PRU 5.1.11

Appropriate systems and controls for the management of liquidity risk will vary with the scale, nature and complexity of the firm's activities. Most of the material in this section is, therefore, guidance. The section lays out some of the main issues that the FSA expects a firm to consider in relation to liquidity risk. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations as set out in Principle 3 to organise and control its affairs responsibly and effectively.

31/12/2004

PRU 5.1.12

For insurers, references to liquidity risk in this section are intended to cover only those aspects of liquidity risk that do not fall under the heading of insurance risk. For such firms, the FSA sees the coverage of this section, broadly, as the management of risk arising from short-term cash-flows, rather than the risk arising from longer-term matching of assets and liabilities, which is part of insurance risk. Guidance on systems and controls for managing insurance risk is set out in PRU 7.1.

31/12/2004

PRU 5.1.13

The FSA recognises that a typical firm of a type described in PRU 5.1.4 R generally faces liquidity risk from a wider range of sources and of greater significance than a typical insurer. This section therefore explicitly applies some items of guidance to firms in PRU 5.1.4 R. Other parts of the guidance are also not relevant to many insurers. In particular, where the guidance refers to factors that a firm should consider in relation to a specific type of business, a firm that does not undertake such business does not need to carry out such consideration.

31/12/2004

PRU 5.1.14

This section addresses the need to have appropriate systems and controls to deal both with liquidity management issues under normal market conditions, and with stressed or extreme situations resulting from either general market turbulence or firm-specific difficulties.

31/12/2004

Requirements

PRU 5.1.15

High level requirements for prudential systems and controls including for liquidity risk are set out in PRU 1.4. In particular:

(1) PRU 1.4.18 R requires a firm, among other things, to take reasonable steps to ensure the establishment of a business plan and appropriate systems for the management of prudential risk; and
(2) PRU 1.4.19 R (2) requires a firm, among other things, to document its policy for managing liquidity risk, including its appetite or tolerance for this risk and how it identifies, measures, monitors and controls this risk.

31/12/2004

PRU 5.1.16

This section sets out guidance on each of these areas, and notes a number of matters which the FSA would expect a firm to deal with in its liquidity risk policy statement as follows:

(1) its liquidity risk strategy (see PRU 5.1.23 G to PRU 5.1.25 G), including:

(a) the role of marketable, or otherwise realisable, assets (see PRU 5.1.32 G); and
(b) its strategy for mitigating liquidity risk on the liability side (see PRU 5.1.37 G);

(2) its method for measuring liquidity risk (see PRU 5.1.55 G);
(3) its system for monitoring liquidity risk (see PRU 5.1.63 G); and
(4) its system for controlling liquidity risk (see PRU 5.1.71 G).

31/12/2004

PRU 5.1.17

High level requirements in relation to carrying out stress testing and scenario analysis are set out in PRU 1.2. In particular, PRU 1.2.35 R requires a firm to carry out appropriate stress testing and scenario analysis. This section gives guidance in relation to these tests in the case of liquidity risk.

31/12/2004

Firms with group liquidity management

PRU 5.1.18

Firms with group liquidity management should refer to PRU 1.4.14 G to PRU 1.4.16 G.

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Managing liquidity risk

PRU 5.1.19

This section amplifies the general requirements in PRU 1.4 by describing the key high level arrangements that the FSA would normally expect to be in place to ensure that a firm's liquidity risk management system is adequate.

31/12/2004

Governing body and senior management oversight

PRU 5.1.20

PRU 1.4.11 G amplifies SYSC 2.1.1 R and SYSC 2.1.3 R which require the apportionment, and allocation, of significant responsibilities to be such that the business and affairs of the firm can be adequately monitored and controlled by the directors, relevant senior executives and governing body of the firm. Effective liquidity risk management entails an informed board, capable management and appropriate staffing. The governing body and senior management are responsible for understanding the nature and level of liquidity risk assumed by the firm and the tools used to manage that risk.

31/12/2004

PRU 5.1.21

In relation to liquidity risk, the governing body's responsibilities should normally include:

(1) approving the firm's liquidity risk policy, which includes taking reasonable steps to ensure that it is consistent with the firm's expressed risk tolerance (see PRU 5.1.23 G to PRU 5.1.25 G);
(2) establishing a structure for the management of liquidity risk including the allocation of appropriate senior managers who have the authority and responsibility to manage liquidity risk effectively, including the establishment and maintenance of the firm's liquidity risk policy;
(3) monitoring the firm's overall liquidity risk profile on a regular basis and being made aware of any material changes in the firm's current or prospective liquidity risk profile; and
(4) taking reasonable steps to ensure that liquidity risk is adequately identified, measured, monitored and controlled.

31/12/2004

PRU 5.1.22

A firm should have an appropriate senior management structure in place to oversee the daily and long-term management of liquidity risk in line with the governing body- approved liquidity risk policy (see PRU 5.1.23 G to PRU 5.1.25 G). The FSA would normally expect the senior management to:

(1) oversee the development, establishment and maintenance of procedures and practices that translate the goals, objectives and risk tolerances approved by the governing body into operating standards that are consistent with the governing body's intent and understood by the relevant members of a firm's personnel;
(2) adhere to the lines of authority and responsibility that the governing body has established for managing liquidity risk;
(3) oversee the establishment and maintenance of management information (see PRU 5.1.66 G to PRU 5.1.70 G) and other systems that identify, measure, monitor and control the firm's liquidity risk; and
(4) oversee the establishment of effective internal controls over the liquidity risk management process (see PRU 5.1.71 G to PRU 5.1.90 G (Controlling liquidity risk)).

31/12/2004

Liquidity risk policy

PRU 5.1.23

SYSC 3.2.17 G gives guidance, which amplifies SYSC 3.2.6 R, on the need for a firm to plan its business appropriately so that it is able to identify, measure, monitor and control risks of regulatory concern. A firm should, therefore, have an agreed policy for the day-to-day and longer term management of liquidity risk which is appropriate to the nature, scale and complexity of the activities carried on.

31/12/2004

PRU 5.1.24

The liquidity risk policy should cover the general approach that the firm will take to liquidity risk management, including, as appropriate, various quantitative and qualitative targets. This general approach should be communicated to all relevant functions within the organisation and be included in the firm's liquidity risk policy statement.

31/12/2004

PRU 5.1.25

The policy for managing liquidity risk should cover specific aspects of liquidity risk management. So far as appropriate to the nature, scale and complexity of the activities carried on, such aspects might include:

(1) the basis for managing liquidity (for example, regional or central);
(2) the degree of concentrations, potentially affecting liquidity risk, that are acceptable to the firm;
(3) a policy for managing the liability side of liquidity risk (see PRU 5.1.37 G);
(4) the role of marketable, or otherwise realisable, assets (see PRU 5.1.32 G);
(5) ways of managing both the firm's aggregate foreign currency liquidity needs and its needs in each individual currency;
(6) ways of managing market access;
(7) the use of derivatives to minimise liquidity risk; and
(8) the management of intra-day liquidity, where this is appropriate, for instance where the firm is a member of or participates (directly or indirectly) in a system for the intra-day settlement of payments or transactions in investments.

31/12/2004

Identifying liquidity risk

PRU 5.1.26

In order to manage liquidity risk successfully, a firm should be aware of the ways in which its activities can affect its liquidity risk profile, and how outside influences may affect its liquidity position. A firm should consider not only its current liquidity risk, but how existing activities may affect its liquidity risk profile in the future; it should also consider the implications of new products or business lines. This section identifies the main sources of liquidity risk and the key factors that a firm might consider when analysing its liquidity risk profile.

31/12/2004

PRU 5.1.27

PRU 1.2.22 R states that a firm must maintain overall financial resources adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due. The firm should, therefore, ensure that, overall, its financial resources are of appropriate maturity, and in a form which is sufficiently marketable or otherwise realisable, having regard to the expected timing of liabilities and the risk that liabilities may fall due earlier than expected (for which prudent allowance must be made when assessing whether assets are of appropriate maturity or sufficiently realisable).

31/12/2004

Asset liquidity

PRU 5.1.28

A firm's asset portfolio can provide liquidity in three major ways:

(a) through the maturity of an asset;
(b) the sale of an asset for cash; or
(c) the use of an asset as collateral to back other transactions, such as for secured borrowing (including repos), or for deposits with insureds or cedants to back insurance or reinsurance transactions.

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PRU 5.1.29

A firm may incur liquidity risk where inflows from the realisation of assets (at either maturity or time of sale) are less than anticipated because of the crystallisation of credit risk or market risk. Inflows arising from the renewal of secured funding, including repos, are similarly affected, if the haircut (the difference between the value of an asset and the amount lent to the firm by the counterparty using that security as collateral) required by a firm's counterparty is larger than anticipated (see PRU 5.1.39 G).

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PRU 5.1.30

Asset concentrations often increase these sources of liquidity risk. A firm should, therefore, identify significant concentrations within its asset portfolio, including in relation to:

(1) individual counterparties or related groups of counterparties;
(2) credit ratings of the assets in its portfolio;
(3) the proportion of an issue held;
(4) instrument types;
(5) geographical regions; and
(6) economic sectors.

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Marketable assets

PRU 5.1.31

Criteria for the marketability of its assets should be decided by the firm and may reflect the firm's access to, and expertise in, individual markets. In determining the appropriateness of the marketability or realisability of assets, a firm may take into account:

(1) the depth and liquidity of the market, including:

(a) the speed with which assets may be realised;
(b) the likelihood and extent of forced-sale loss; and
(c) the potential for using the asset as collateral in secured funding and the size of the haircut (see PRU 5.1.29 G) likely to be required by the counterparty;

(2) the expected date of maturity, redemption, repayment or disposal;
(3) the proportion of an issue held;
(4) the credit ratings of the assets;
(5) the impact of exchange rate risk on the realised value of the asset, where assets are denominated in different currencies from its liabilities; and
(6) where applicable, the impact on certain assets' liquidity of their use as eligible collateral either in open-market operations conducted by, or in real-time or other payment systems operated by, a central bank.

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PRU 5.1.32

The role of marketable, or otherwise realisable, assets in a firm's liquidity risk policy, in both normal and stressed conditions, should be set out in its liquidity risk policy statement.

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PRU 5.1.33

In considering the marketability of an asset, a firm should assess how its value and liquidity would be affected in a variety of scenarios (see PRU 5.1.58 G to PRU 5.1.60 G, PRU 5.1.61 E and PRU 5.1.62 G).

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Adjusting for the behavioural characteristics of assets

PRU 5.1.34

In order to manage its liquidity risk effectively, a firm should be able to adjust for the behavioural characteristics of the repayment profiles of assets, that is how their actual behaviour may vary from that suggested by their contractual terms. Such an adjustment may be necessary in order to reduce the risk of wrongly estimating the inflows in relation to, in particular:

(1) standby facilities or other commitments that have already been drawn down;
(2) retail and wholesale overdrafts;
(3) mortgages; and
(4) credit cards.

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PRU 5.1.35

The repayment profiles should be considered under both normal market conditions and stressed conditions resulting from either general market turbulence or firm-specific difficulties (see PRU 5.1.58 G to PRU 5.1.60 G, PRU 5.1.61 E and PRU 5.1.62 G, and PRU 5.1.85 G, PRU 5.1.86 E, and PRU 5.1.87 G to PRU 5.1.90 G).

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Inflows from off balance sheet items

PRU 5.1.36

Where a firm has in place a committed facility for the provision of a portion of its funding, it should take care to monitor any covenants included in the agreement. It should also make efforts to retain a good relationship with the provider of the facility and, where possible without jeopardising that relationship, regularly test access to the funds. A firm should also assess the extent to which committed facilities can be relied upon under stressed conditions (see PRU 5.1.62G (1)(c) and PRU 5.1.88 G (4)).

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Liability liquidity

PRU 5.1.37

Holding marketable, or otherwise realisable, assets is not the only way for a firm to mitigate the liquidity risk it faces. There are a number of liability-side strategies that can be used to reduce a firm's liquidity risk, such as ensuring a spread of maturities and lengthening the term structure of its liabilities. In order to manage its liquidity risk effectively a firm should have a liability-side policy that is appropriate to the nature and scale of its activities; this policy should be described in its liquidity risk policy statement.

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PRU 5.1.38

When determining the appropriate mix of liabilities, a firm's management should consider potential concentrations. A concentration exists when a single decision or factor could cause a significant and sudden claim on liabilities. What constitutes a liability concentration depends on the nature and scale of a firm's activities. A firm should, however, normally consider:

(1) the term structure of its liabilities;
(2) the credit-sensitivity of its liabilities;
(3) the mix of secured and unsecured funding;
(4) concentrations among its liability providers, or related groups of liability providers;
(5) reliance on particular instruments or products;
(6) the geographical location of liability providers; and
(7) reliance on intra-group funding.

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PRU 5.1.39

A firm with credit-sensitive liabilities should be aware that, in times of market turbulence, a proportion of that funding may be withdrawn, particularly funding which is unsecured. Secured funding may also be affected, with counterparties seeking better quality collateral or larger haircuts (see PRU 5.1.29 G) on collateral. A firm should recognise these characteristics of its credit-sensitive liabilities and take account of them in its stress testing and scenario analysis and contingency funding plan (see PRU 5.1.58 G to PRU 5.1.60 G, PRU 5.1.61 E and PRU 5.1.62 G, and PRU 5.1.85 G, PRU 5.1.86 E, and PRU 5.1.87 G to PRU 5.1.90 G).

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PRU 5.1.40

A firm should consider the dynamics of its liquidity risk including, for example, the normal level of roll-overs, and growth, of liabilities.

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Adjusting for the behavioural characteristics of liabilities

PRU 5.1.41

In order to meet the requirement to maintain sufficient liquid financial resources (see PRU 5.1.27 G), a firm should consider the behavioural characteristics of its liabilities, that is how their actual behaviour may vary from that suggested by their contractual terms.

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PRU 5.1.42

In assessing how to adjust for the behavioural characteristics of its liabilities in the context of liquidity risk, an insurer may take into account:

(1) the type of insurance business;
(2) the past history of volatility in the pattern of claims payment;
(3) options available to policyholders and the circumstances in which they are likely to be exercised;
(4) options available to the insurer and any incentive for the insurer to exercise them;
(5) any relevant requirements to deposit collateral either with the insured (or cedants) under the terms of the insurance Treaty or by requirements of overseas regulators as a condition for covering risks in a particular territory; and
(6) the other cash flow needs of the business.

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Outflows from off balance sheet items

PRU 5.1.43

The contingent or optional nature of many off balance sheet instruments adds to the complexity of managing off balance sheet cash flows. In particular, in stressed conditions off balance sheet commitments may be a significant drain on liquidity.

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PRU 5.1.44

A firm should consider how its wholesale off balance sheet activities affect its cash flows and liquidity risk profile under both normal and stressed conditions. In particular, as appropriate, it should consider the amount of funding required by:

(1) commitments given;
(2) standby facilities given;
(3) wholesale overdraft facilities given;
(4) proprietary derivatives positions; and
(5) liquidity facilities given for securitisation transactions.

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PRU 5.1.45

Similarly, a firm with retail customers should be able to assess the likely draw-down on retail products under a variety of circumstances and taking into account seasonal factors. In particular, as appropriate, it should consider the amount of funding required in relation to:

(1) mortgages that have been agreed but not yet drawn down;
(2) overdrafts; and
(3) credit cards.

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Asset securitisations

PRU 5.1.46

If controlled properly, asset securitisation can be a useful tool in enhancing a firm's liquidity. However, features of certain securitisations, such as early amortisation triggers, as well as excessive reliance on a single funding vehicle, can increase liquidity risk.

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PRU 5.1.47

The implications of securitisations on a firm's liquidity position should be considered for both day-to-day liquidity management and its contingency planning for liquidity risk. A contemplated securitisation should be analysed for its impact on liquidity risk. A firm using securitisation should consider:

(1) the volume of securities issued in connection with the securitisation that are scheduled to amortise during any particular period;
(2) the existence of early amortisation triggers (see also PRU 5.1.62G (3)(c);
(3) its plans for meeting its funding requirements (including their timing);
(4) strategies for obtaining substantial amounts of liquidity at short notice (see also PRU 5.1.86 E and PRU 5.1.88 G); and
(5) operational issues associated with the rollover of short-dated securities, particularly commercial paper.

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PRU 5.1.48

If a firm is a provider of liquidity facilities for securitisation transactions it should be able to assess the probability and scale of draw-down and make provision for it.

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PRU 5.1.49

A firm using securitisation should also be aware that its ability to securitise assets may diminish in stressed market conditions and take account of this in its stress testing and contingency funding plan. In addition, the time taken to organise a securitisation transaction may mean that it cannot be relied upon to provide liquidity at short notice.

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Foreign currency liquidity

PRU 5.1.50

Foreign currency liquidity risk arises where a firm faces actual or potential future outflows in a particular currency which it may not be able to meet from likely available inflows in that currency. A firm's exposure to foreign currency liquidity risk depends on the nature, scale and complexity of its business. Where a firm has significant, unhedged liquidity mismatches in particular currencies, it should consider:

(1) the volatilities of the exchange rates of the mismatched currencies;
(2) likely access to the foreign exchange markets in normal and stressed conditions; and
(3) the stickiness of deposits in those currencies with the firm in stressed conditions.

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PRU 5.1.51

A possible strategy for mitigating foreign currency liquidity risk, which is effective and simple, is for a firm to hold assets in a particular currency in an amount equal to, and realisable at maturities no later than, its liabilities in that currency. This strategy may be worth considering particularly where, as a result of the nature, scale and complexity of its business, a firm's liquidity risk is relatively small.

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Intra-day liquidity

PRU 5.1.52

SYSC 3.1.1 R requires a firm to take reasonable care to establish and maintain systems and controls appropriate to its business. This includes appropriate systems and controls over activities that give rise to significant market, credit, liquidity, insurance, operational or group risk, including over the processes of settling and paying debts and other commitments that arise from those activities.

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PRU 5.1.53

Structural and operational changes in payment systems have increased the importance of intra-day liquidity for many firms. Within real time gross settlement systems, for example, a firm needs to take appropriate steps to ensure that it has sufficient collateral to cover cash positions and has systems capable of monitoring intra-day liquidity positions and cash needs.

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PRU 5.1.54

A firm should be aware that in stressed conditions it is likely to require more intra-day liquidity than in normal market conditions, for a variety of reasons including payments due to the firm being delayed and wholesale depositors withdrawing from the market. A firm should take account of this in its stress testing and scenario analysis.

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Measuring liquidity risk

PRU 5.1.55

A firm should establish and maintain a process for the measurement of liquidity risk, using a robust and consistent method which should be described in its liquidity risk policy statement.

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PRU 5.1.56

A number of techniques can be used for measuring liquidity risk, ranging from simple calculations to highly sophisticated modelling; a firm should use a measurement method which is appropriate to the nature, scale and complexity of its activities.

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PRU 5.1.57

The method that a firm uses for measuring liquidity risk should be capable of:

(1) measuring the extent of the liquidity risk it is incurring;
(2) dealing with the dynamic aspects of a firm's liquidity profile (for example, rollovers of funding and assets or new business);
(3) assessing the behavioural characteristics of its on and off balance sheet instruments; and
(4) where appropriate, measuring the firm's exposure to foreign currency liquidity risk.

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Stress testing and scenario analysis

PRU 5.1.58

PRU 1.2.26 R, PRU 1.2.27 R, PRU 1.2.31 R, PRU 1.2.33 R and PRU 1.2.35 R entail that, for the purposes of determining the adequacy of its overall financial resources, a firm must carry out appropriate stress testing and scenario analysis, including taking reasonable steps to identify an appropriate range of realistic adverse circumstances and events in which liquidity risk might occur or crystallise.

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PRU 5.1.59

PRU 1.2.36 G and PRU 1.2.40 G to PRU 1.2.55 G give guidance on stress testing and scenario analysis, including on how to choose appropriate scenarios, but the precise scenarios that a firm chooses to use will depend on the nature of its activities. For the purposes of testing liquidity risk, however, a firm should normally consider scenarios based on varying degrees of stress and both firm-specific and market-wide difficulties. In developing any scenario of extreme market-wide stress that may pose systemic risk, it may be appropriate for a firm to make assumptions about the likelihood and nature of central bank intervention.

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PRU 5.1.60

A firm should review frequently the assumptions used in stress testing scenarios to gain assurance that they continue to be appropriate.

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PRU 5.1.61

(1) A scenario analysis in relation to liquidity risk required under PRU 1.2.35 R should include a cash-flow projection for each scenario tested, based on reasonable estimates of the impact (both on and off balance sheet) of that scenario on the firm's funding needs and sources.
(2) Contravention of (1) may be relied on as tending to establish contravention of PRU 1.2.35 R.

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PRU 5.1.62

In identifying the possible on and off balance sheet impact referred to in PRU 5.1.61E (1), a firm may take into account:

(1) possible changes in the market's perception of the firm and the effects that this might have on the firm's access to the markets, including:

(a) (where the firm funds its holdings of assets in one currency with liabilities in another) access to foreign exchange markets, particularly in less frequently traded currencies;
(b) access to secured funding, including by way of repo transactions; and
(c) the extent to which the firm may rely on committed facilities made available to it;

(2) (if applicable) the possible effect of each scenario analysed on currencies whose exchange rates are currently pegged or fixed; and
(3) that:

(a) general market turbulence may trigger a substantial increase in the extent to which persons exercise rights against the firm under off balance sheet instruments to which the firm is party;
(b) access to OTC derivative and foreign exchange markets are sensitive to credit-ratings;
(c) the scenario may involve the triggering of early amortisation in asset securitisation transactions with which the firm has a connection; and
(d) its ability to securitise assets may be reduced.

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Monitoring liquidity risk

PRU 5.1.63

A firm should establish and maintain an appropriate system for monitoring its liquidity risk, which should be described in its liquidity risk policy statement.

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PRU 5.1.64

A firm should establish and maintain a system of management reporting which provides clear, concise, timely and accurate liquidity risk reports to relevant functions within the firm. These reports should alert management when the firm approaches, or breaches, predefined thresholds or limits, including quantitative limits imposed by the FSA or another regulator.

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PRU 5.1.65

Where a firm is a member of a group, it should be able to assess the potential impact on it of liquidity risk arising in other parts of the group.

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Management information systems

PRU 5.1.66

A firm should have adequate information systems for controlling and reporting liquidity risk. The management information system should be used to check for compliance with the firm's established policies, procedures and limits.

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PRU 5.1.67

Reports on liquidity risk should be provided on a timely basis to the firm's governing body, senior management and other appropriate personnel. The appropriate content and format of reports depends on a firm's liquidity management practices and the nature, scale and complexity of the firm's business. Reports to the firm's governing body may be less detailed and less frequent than reports to senior management with responsibility for managing liquidity risk.

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PRU 5.1.68

For a firm described in PRU 5.1.4 R, management information would normally contain the following:

(1) a cash-flow or funding gap report;
(2) a funding maturity schedule;
(3) a list of large providers of funding; and
(4) a limit monitoring and exception report.

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PRU 5.1.69

When considering what else might be included in liquidity risk management information, a firm should consider other types of information that may be important for understanding its liquidity risk profile.

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PRU 5.1.70

For a firm described in PRU 5.1.4 R, the additional information referred to in PRU 5.1.69 G may include:

(1) asset quality and trends;
(2) any changes in the firm's funding strategy;
(3) earnings projections; and
(4) the firm's reputation in the market and the condition of the market itself.

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Controlling liquidity risk

PRU 5.1.71

A firm should establish and maintain an appropriate system for controlling its liquidity risk, which should be described in its liquidity risk policy statement. Such a system should allow the firm's governing body and senior management to review compliance with established limits and operating procedures.

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PRU 5.1.72

A firm should have in place appropriate approval processes, limits and other mechanisms designed to provide reasonable assurance that the firm's liquidity risk management processes are adhered to.

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PRU 5.1.73

When revisions or enhancements to internal controls are warranted, a firm should implement them in a timely manner.

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PRU 5.1.74

The effectiveness of a firm's liquidity risk management system should be regularly reviewed and evaluated by individuals unconnected with day-to-day liquidity risk management in order to check that personnel are following established policies and procedures, and that procedures accomplish the intended objectives.

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PRU 5.1.75

In addition to the regular review and evaluation described in PRU 5.1.74 G, a firm's internal audit function should periodically review the liquidity risk management process in order to identify any weaknesses or problems. Any weaknesses should be addressed by management in a timely and effective manner.

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Limit setting

PRU 5.1.76

A firm's senior management should decide what limits need to be set, in accordance with the nature, scale and complexity of its activities. The structure of limits should reflect the need for a firm to have systems and controls in place to guard against a spectrum of possible risks, from those arising in day-to-day liquidity risk management to those arising in stressed conditions.

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PRU 5.1.77

PRU 1.4.18 R states that a firm must take reasonable steps to ensure the establishment and maintenance of a business plan and appropriate systems for the management of prudential risk.

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PRU 5.1.78

(1) If a firm has liquidity risk that arises because it has substantial exposures in foreign currencies, the risk management systems of the firm referred to in PRU 1.4.18 R should include systems and procedures that are designed to ensure that the firm does not, except in accordance with those procedures, exceed limits that are designed to limit:

(a) the aggregate amount of its liquidity risk for all exposures in foreign currencies; and
(b) the amount of its liquidity risk for each individual currency in which it has a significant exposure.

(2) Contravention of (1) may be relied upon as tending to establish contravention of PRU 1.4.18 R.

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PRU 5.1.79

The FSA would normally expect a firm described in PRU 5.1.4 R to consider setting limits on:

(1) liability concentrations in relation to:

(a) individual, or related groups of, liability providers;
(b) instrument types;
(c) maturities, including the amount of debt maturing in a particular period; and
(d) retail and wholesale liabilities; and

(2) where appropriate, net leverage and gross leverage.

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PRU 5.1.80

A firm should periodically review and, where appropriate, adjust its limits when conditions or risk tolerances change.

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PRU 5.1.81

Policy or limit exceptions should receive the prompt attention of the appropriate management and should be resolved according to processes described in approved policies.

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Managing market access

PRU 5.1.82

A firm should periodically review its efforts to establish and maintain relationships with liability providers, to maintain adequate diversification of liabilities, and to ensure adequate capacity to sell assets, or use them as collateral in secured funding. Where possible the firm should aim regularly to test its access to the individual markets in assets that it holds for liquidity purposes.

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PRU 5.1.83

Market access should be assessed under a variety of normal and stressed conditions.

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PRU 5.1.84

In some circumstances, the disclosure of information about a firm may be useful in managing the public perception of its organisation and soundness. A firm should consider the role of disclosure in managing the liquidity risk to which it is exposed.

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Contingency funding plans

PRU 5.1.85

PRU 1.2.22 R states that a firm must at all times maintain overall financial resources adequate to ensure that there is no significant risk that its liabilities cannot be met as they fall due.PRU 1.2.3 R (2) states that for the purposes of determining the adequacy of its overall financial resources, a firm must estimate the financial resources it would need in each of the circumstances and events considered in carrying out its stress testing and scenario analysis in order to meet its liabilities as they fall due.

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PRU 5.1.86

(1) A firm should have a contingency funding plan for taking action to ensure, so far as it can, that, in each of the scenarios analysed under PRU 1.2.3 R (2), it would still have sufficient liquid financial resources to meet liabilities as they fall due.
(2) The contingency funding plan should cover what events or circumstances will lead the firm to put into action any part of the plan.
(3) Contravention of (1) or (2) may be relied upon as tending to establish contravention of PRU 1.2.22 R.

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PRU 5.1.87

A firm should adequately document the contingency funding plan referred to in PRU 5.1.86 E.

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PRU 5.1.88

The contingency funding plan of a firm described in PRU 5.1.4 R should cover the extent to which the actions in PRU 5.1.86E (1) include:

(1) selling, using as collateral in secured funding (including repo), or securitising, its assets;
(2) otherwise reducing its assets;
(3) modifying the structure of its liabilities or increasing its liabilities; and
(4) the use of committed facilities.

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PRU 5.1.89

A firm's contingency funding plan should, where relevant, take account of the impact of stressed market conditions on:

(1) the behaviour of any credit-sensitive liabilities it has; and
(2) its ability to securitise assets.

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PRU 5.1.90

The contingency funding plan should contain administrative policies and procedures that will enable the firm to manage the plan's implementation effectively, including:

(1) the responsibilities of senior management;
(2) names and contact details of members of the team responsible for implementing the contingency funding plan;
(3) where, geographically, team members will be assigned;
(4) who within the team is responsible for contact with head office (if appropriate), analysts, investors, external auditors, press, significant customers, regulators, lawyers and others; and
(5) mechanisms that enable senior management and the governing body to receive management information that is both relevant and timely.

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Documentation

PRU 5.1.91

PRU 1.2.37 R states that a firm must document its assessment of the adequacy of its liquidity financial resources, how it intends to deal with those risks, and details of the stress tests and scenario analyses carried out and the resulting financial resources estimated to be required. Accordingly, a firm should document both its stress testing and scenario analysis (see PRU 5.1.58 G) and its contingency funding plan (see PRU 5.1.85 G).

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Export chapter as

Legal Instruments that change this Chapter Liquidity

PRU 6

Operational risk

PRU 6.1

Operational Risk: Prudential Systems and Controls

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Application

PRU 6.1.1

PRU 6.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 6.1.2

PRU 6.1 applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

only in respect of the activities of the firm carried on from a branch in the United Kingdom.

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Purpose

PRU 6.1.3

This section provides guidance on how to interpret PRU 1.4.18 R and PRU 1.4.19 R (2) (which relate to the design and documentation of risk management systems) in so far as they relate to the management of operational risk in a prudential context. Operational risk has been described by the Basel Committee on Banking Supervision as "the risk of loss, resulting from inadequate or failed internal processes, people and systems, or from external events". Thus this section covers systems and controls relating to risks concerning any of the firm's operations, whether caused by internal or external matters. However, it does not cover systems and controls as they relate to credit, market, liquidity and insurance risk. Examples of operational risk exposures that the systems and controls covered in this section are meant to address include internal and external fraud; failure to comply with employment law or meet workplace safety standards; damage to physical assets; business disruptions and system failures; and transaction processing failures.

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PRU 6.1.4

Operational risk concerns the FSA in a prudential context because inappropriate systems and controls for the management of operational risk can adversely affect the solvency or business continuity of a firm, threatening the regulatory objectives of market confidence and consumer protection.

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PRU 6.1.5

This section contains guidance on how a firm should determine, in a prudential context, its policy for operational risk management and its processes for the identification, assessment, monitoring and control of operational risk. In addition, guidance is provided on record keeping in relation to operational risk.

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PRU 6.1.6

The guidance contained within this section is not designed to be exhaustive. When establishing and maintaining its systems and controls for operational risk, a firm should have regard to other parts of the Handbook as well as the material that is issued by other industry or regulatory bodies. In particular, a firm should read this section in conjunction with SYSC 3A (Operational Risk Systems and Controls) which contains high level guidance on the management of people, processes and systems, and external events in relation to operational risk. SYSC 3A also outlines some guidance on the areas that are covered by operational risk systems and controls (including the FSA's interpretation of some frequently used risk management terms in relation to operational risk), business continuity management, outsourcing, and the role of insurance in financing operational risk. In addition, a firm should read PRU 1.4, which contains the FSA's general policy on prudential systems and controls. PRU 1.4 contains some rules and guidance on which this section offers additional guidance.

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PRU 6.1.7

Guidance on the application of this section to a firm that is a member of a group is provided in PRU 8.1 (Group Risk Systems and Controls).

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PRU 6.1.8

Appropriate systems and controls for the management of operational risk will vary with the scale, nature and complexity of a firm's activities. Therefore the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations as set out in Principle 3 to organise and control its affairs responsibly and effectively.

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General Requirements

PRU 6.1.9

High level rules and guidance for prudential systems and controls including those for operational risk are set out in PRU 1.4. In particular:

(1) PRU 1.4.18 R requires a firm to take reasonable steps to ensure that the risk management systems put in place to identify, assess, monitor and control operational risk are adequate for that purpose;
(2) PRU 1.4.19 R (2) requires a firm to document its policy for operational risk, including its risk appetite and how it identifies, assesses, monitors and controls that risk; and
(3) PRU 1.4.27 R requires a firm to take reasonable steps to establish and maintain adequate internal controls to enable it to assess and monitor the effectiveness and implementation of its business plan and prudential risk management systems.

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Operational risk policy

PRU 6.1.10

Much of the management of operational risk is about identifying, assessing, monitoring and controlling failures or inadequacies in a firm's systems and controls. As such, a firm may often find that there is no clear boundary between its risk management systems for operational risk and all its other systems and controls. When drafting its operational risk policy, a firm should try to distinguish between its systems and controls for credit, market, liquidity and insurance risk, and its systems and controls for operational risk. Where such a distinction is not possible a firm should still try to identify those systems and controls that are used in the management of operational risk, even when they have other purposes as well.

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PRU 6.1.11

A firm should document its policy for managing operational risk. This policy should outline a firm's strategy and objectives for operational risk management and the processes that it intends to adopt to achieve these objectives. In complying with PRU 1.4.19 R (2), the documented operational risk policy of a firm should include:

(1) an analysis of the firm's operational risk profile (see the FSA's interpretation of this term in SYSC 3A.5.1 G (3)), including where relevant some consideration of the effects that operational risk may have on the firm, including consideration of those operational risks within a firm that may have an adverse impact upon the quality of service afforded to its clients;
(2) the operational risks that the firm is prepared to accept and those that it is not prepared to accept, including where relevant some consideration of its appetite or tolerance (see PRU 6.1.13 G) for specific operational risks;
(3) how the firm intends to identify, assess, monitor, and control its operational risks, including an overview of the people, processes and systems that are used; and
(4) where assessments of the firm's risk exposures are used for internal capital allocation purposes, a description of how operational risk is incorporated into this methodology.

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PRU 6.1.12

A firm may also wish to set threshold levels in its operational risk policy for particular types of operational risk (based on its risk appetite or tolerance for risk), which when exceeded trigger a response (such as the allocation of more resources to control the risk or a reappraisal of business plans).

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PRU 6.1.13

Given its association with a willingness to take risk, a firm may wish to replace the term appetite for tolerance when drafting its operational risk policy. Tolerance describes the types and degree of operational risk that a firm is prepared to incur (based on factors such as the adequacy of its resources and the nature of its operating environment). Tolerance may be described in terms of the maximum budgeted (that is, expected) costs of an operational risk that a firm is prepared to bear, or by reference to risk indicators such as the cost or number of system failures, available spare capacity and the number of failed trades.

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PRU 6.1.14

The term risk assessment can be used to represent both the qualitative and quantitative evaluation or measurement of operational exposures.

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Risk identification

PRU 6.1.15

In order to understand its operational risk profile, a firm should identify the types of operational risk that it is exposed to as far as reasonably possible. This might include, but is not limited to, consideration of:

(1) the nature of a firm's customers, products and activities, including sources of business, distribution mechanisms, and the complexity and volumes of transactions;
(2) the design, implementation, and operation of the processes and systems used in the end-to-end operating cycle for a firm's products and activities;
(3) the risk culture and human resource management practices at a firm; and
(4) the business operating environment, including political, legal, socio-demographic, technological, and economic factors as well as the competitive environment and market structure.

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PRU 6.1.16

A firm should recognise that it may face significant operational exposures from a product or activity that may not be material to its business strategy. A firm should consider the appropriate level of detail at which risk identification is to take place, and may wish to manage the operational risks that it faces in risk categories that are appropriate to its organisational and legal structures.

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PRU 6.1.17

The FSA's interpretation of the term operational exposure is provided in SYSC 3A.5.1 G (2).

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Risk assessment

PRU 6.1.18

The FSA recognises that risk management systems for operational risk are still developing, and that it may be neither feasible nor appropriate to measure certain types of operational risk in a quantitative way. A firm may wish to take a qualitative approach to the assessment of its operational risks using, for example, relative estimates (such as high, medium, low) to understand its exposure to them.

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PRU 6.1.19

In order to understand the effects of its operational exposures a firm should continually assess its operational risks. This might include, but is not limited to, consideration of:

(1) actual operational losses that have occurred within a firm, or events that could have resulted in significant operational losses, but were avoided (for example, the waiving of financial penalties by a third party as a gesture of goodwill or where by chance the firm realised profits);
(2) internal assessment of risks inherent in its operations and the effectiveness of controls implemented to reduce these risks (through activities such as self-assessment or stress testing and scenario analysis);
(3) other risk indicators, such as customer complaints, processing volumes, employee turnover, large numbers of reconciling items, process or system failures, fragmented systems, systems subject to a high degree of manual intervention and transactions processed outside a firm's mainstream systems;
(4) reported external (peer) operational losses and exposures; and
(5) changes in its business operating environment.

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PRU 6.1.20

When assessing its operational risks, a firm may be able to differentiate between expected and unexpected operational losses. A firm should consider whether it is appropriate to adopt a more quantitative approach to the assessment of its expected operational losses, for example by defining tolerance, setting thresholds, and measuring and monitoring operational losses and exposures. In contrast, a firm may wish to take a more qualitative approach to assessing its unexpected losses.

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PRU 6.1.21

Although a firm may currently be unable to assess certain operational risks with a high degree of accuracy or consistency, it should, according to the nature, scale and complexity of its business, consider the use of more sophisticated qualitative and quantitative techniques as they become available.

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Risk monitoring

PRU 6.1.22

In monitoring its operational risks, a firm should:

(1) as appropriate, regularly report to the relevant level of management its operational exposures, loss experience (including if possible cumulative losses), and authorised deviations from the firm's operational risk policy;
(2) engage in exception-based escalation to management of:

(a) unauthorised deviations from the firm's operational risk policy;
(b) likely or actual breaches in predefined thresholds for operational exposures and losses, where set; and
(c) significant increases in the firm's exposure to operational risk or alterations to its operational risk profile.

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Risk control

PRU 6.1.23

A firm should control its operational risks, as appropriate, through activities for the avoidance, transfer, prevention or reduction of the likelihood of occurrence or potential impact of an operational exposure. This might include, but is not limited to, consideration of:

(1) adjusting a firm's risk culture and creating appropriate incentives to facilitate the implementation of its risk control strategy (see SYSC 3A.6 People);
(2) adapting internal processes and systems (see SYSC 3A.7 Processes and systems);
(3) transferring or changing the operational exposure through mechanisms such as outsourcing (see SYSC 3A.9 Outsourcing) and insurance (see SYSC 3A.10 Insurance);
(4) the active acceptance of a given operational risk within the firm's stated risk appetite or tolerance; and
(5) providing for expected losses, and maintaining adequate financial resources against unexpected losses that may be encountered in the normal course of a firm's business activities.

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Record keeping

PRU 6.1.24

The FSA's high level rules and guidance for record keeping are outlined in SYSC 3.2.20 R (Records). Additional rules and guidance in relation to the prudential context are set out in PRU 1.4.51 G to PRU 1.4.64 G (Record keeping). In complying with these rules and all associated guidance, a firm should retain an appropriate record of its operational risk management activities. This may, for example, include records of:

(1) the results of risk identification, measurement, and monitoring activities;
(2) actions taken to control identified risks;
(3) where relevant, any exposure thresholds that have been set for identified operational risks;
(4) an assessment of the effectiveness of the risk control tools that are used; and
(5) actual exposures against stated risk appetite or tolerance.

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Export chapter as

Legal Instruments that change this Chapter Operational risk

PRU 7

Insurance risk

PRU 7.1

Insurance risk systems and controls

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Application

PRU 7.1.1

PRU 7.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 7.1.2

PRU 7.1 applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

only in respect of the activities of the firm carried on from a branch in the United Kingdom.

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Purpose

PRU 7.1.3

This section provides guidance on how to interpret PRU 1.4 (Prudential risk management and associated systems and controls) in so far as it relates to the management of insurance risk. Insurance risk refers to fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the firm at the time of underwriting. Insurance risk can also refer to fluctuations in the timing and amount of claim settlements. For general insurance business some specific examples of insurance risk include variations in the amount or frequency of claims or the unexpected occurrence of multiple claims arising from a single cause. For long-term insurance business examples include variations in the mortality and persistency rates of policyholders, or the possibility that guarantees could acquire a value that adversely affects the finances of a firm and its ability to treat its policyholders fairly consistent with the firm's obligations under Principle 6. More generally, insurance risk includes the potential for expense overruns relative to pricing or provisioning assumptions.

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PRU 7.1.4

Insurance risk concerns the FSA in a prudential context because inadequate systems and controls for its management can create a threat to the regulatory objectives of market confidence and consumer protection. Inadequately managed insurance risk may result in:

(1) the inability of a firm to meet its contractual insurance liabilities as they fall due; and
(2) the inability of a firm to treat its policyholders fairly consistent with the firm's obligations under Principle 6 (for example, in relation to bonus payments).

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PRU 7.1.5

Guidance on the application of this section to a firm that is a member of a group is provided in PRU 8.1 (Group risk systems and controls).

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PRU 7.1.6

The guidance contained within this section should be read in conjunction with SYSC and PRU 1.4.

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PRU 7.1.7

Appropriate systems and controls for the management of insurance risk will vary with the scale, nature and complexity of a firm's activities. Therefore, the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations, as set out in Principle 3, to organise and control its affairs responsibly and effectively.

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General requirements

PRU 7.1.8

High level rules and guidance for prudential systems and controls for insurance risk are set out in PRU 1.4. In particular:

(1) PRU 1.4.18 R requires a firm to take reasonable steps to establish and maintain a business plan and appropriate risk management systems;
(2) PRU 1.4.19R (2) requires a firm to document its policy for insurance risk, including its risk appetite and how it identifies, measures, monitors and controls that risk; and
(3) PRU 1.4.27 R requires a firm to take reasonable steps to establish and maintain adequate internal controls to enable it to assess and monitor the effectiveness and implementation of its business plan and prudential risk management systems.

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Insurance risk policy

PRU 7.1.9

A firm's insurance risk policy should outline its objectives in carrying out insurance business, its appetite for insurance risk and its policies for identifying, measuring, monitoring and controlling insurance risk. The insurance risk policy should cover any activities that are associated with the creation or management of insurance risk. For example, underwriting, claims management and settlement, assessing technical provisions in the balance sheet, risk mitigation and risk transfer, record keeping and management reporting. Specific matters that should normally be in a firm's insurance risk policy include:

(1) a statement of the firm's willingness and capacity to accept insurance risk;
(2) the classes and characteristics of insurance business that the firm is prepared to accept;
(3) the underwriting criteria that the firm intends to adopt, including how these can influence its rating and pricing decisions;
(4) its approach to limiting significant aggregations of insurance risk, for example, by setting limits on the amount of business that can be underwritten in one region or with one policyholder;
(5) where relevant, the firm's approach to pricing long-term insurance contracts, including the determination of the appropriate level of any reviewable premiums;
(6) the firm's policy for identifying, monitoring and managing risk when it has delegated underwriting authority to another party (additional guidance on the management of outsourcing arrangements is provided in SYSC 3A.9);
(7) the firm's approach to managing its expense levels, including acquisition costs, recurring costs, and one-off costs, taking account of the margins available in both the prices for products and in the technical provisions in the balance sheet;
(8) the firm's approach to the exercise of any discretion (e.g. on charges or the level of benefits payable) that is available in its long-term insurance contracts, in the context also of the legal and regulatory constraints existing on the application of this discretion;
(9) the firm's approach to the inclusion of options within new long-term insurance contracts and to the possible exercise by policyholders of options on existing contracts;
(10) the firm's approach to managing persistency risk;
(11) the firm's approach to managing risks arising from timing differences in taxation or from changes in tax laws;
(12) the firm's approach to the use of reinsurance or the use of some other means of risk transfer;
(13) how the firm intends to assess the effectiveness of its risk transfer arrangements and manage the residual or transformed risks (for example, how it intends to handle disputes over contract wordings, potential payout delays and counterparty performance risks);
(14) a summary of the data and information to be collected and reported on underwriting, claims and risk control (including internal accounting records), management reporting requirements and external data for risk assessment purposes;
(15) the risk measurement and analysis techniques to be used for setting underwriting premiums, technical provisions in the balance sheet, and assessing capital requirements; and
(16) the firm's approach to stress testing and scenario analysis, as required by PRU 1.2 (Adequacy of financial resources), including the methods adopted, any assumptions made and the use that is to be made of the results.

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PRU 7.1.10

Further, more detailed, guidance is given in PRU 7.1.11 G to PRU 7.1.37 G on the identification, measurement, monitoring and control (including the use of reinsurance and other forms of risk transfer) of insurance risk. A firm should consider what additional material to that set out above should be included in its insurance risk policy on each of these for its various activities.

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Risk identification

PRU 7.1.11

A firm should seek to identify the causes of fluctuations in the occurrence, amount and timing of its insurance liabilities. A firm should also seek to identify aggregations of risk that may give rise to large single or multiple claims.

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PRU 7.1.12

The identification of insurance risk should normally include:

(1) in connection with the firm's business plan:

(a) processes for identifying the types of insurance risks that may be associated with a new product and for comparing the risk types that are present in different classes of business (in order to identify possible aggregations in particular insurance risks); and
(b) processes for identifying business environment changes (for example landmark legal rulings) and for collecting internal and external data to test and modify business plans;

(2) at the point of sale, processes for identifying the underwriting risks associated with a particular policyholder or a group of policyholders (for example, processes for identifying potential claims for mis-selling and for collecting information on the claims histories of policyholders, including whether they have made any potentially false or inaccurate claims, to identify possible adverse selection or moral hazard problems);
(3) after the point of sale, processes for identifying potential and emerging claims for the purposes of claims management and claims provisioning; this could include:

(a) identifying possible judicial rulings;
(b) keeping up to date with developments in market practice; and
(c) collecting information on industry wide initiatives and settlements.

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PRU 7.1.13

A firm should also identify potential pricing risks, where the liabilities or costs arising from the sale of a product may not be as expected.

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Risk measurement

PRU 7.1.14

A firm should have in place appropriate systems for collecting the data it needs to measure insurance risk. At a minimum this data should be capable of allowing a firm to evaluate the types of claims experienced, claims frequency and severity, expense levels, persistency levels and, where relevant, potential changes in the value of guarantees and options in long-term insurance contracts.

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PRU 7.1.15

A firm should ensure that the data it collects and the measurement methodologies that it uses are sufficient to enable it to evaluate, as appropriate:

(1) its exposure to insurance risk at all relevant levels, for example, by contract, policyholder, product line or insurance class;
(2) its exposure to insurance risk across different geographical areas and time horizons;
(3) its total, firm-wide, exposure to insurance risk and any other risks that may arise out of the contracts of insurance that it issues;
(4) how changes in the volume of business (for example via changes in premium levels or the number of new contracts that are underwritten) may influence its exposure to insurance risk;
(5) how changes in policy terms may influence its exposure to insurance risk; and
(6) the effects of specific loss scenarios on the insurance liabilities of the firm.

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PRU 7.1.16

A firm should hold data in a manner that allows for it to be used in a flexible way. For example, data should be sufficiently detailed and disaggregated so that contract details may be aggregated in different combinations to assess different risks.

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PRU 7.1.17

A firm should be able to justify its choice of measurement methodologies. This justification should normally be documented.

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PRU 7.1.18

A firm should periodically review the appropriateness of the measurement methodologies that it uses. This could, for example, include back testing (that is, by comparing actual versus expected results) and updating for changes in market practice.

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PRU 7.1.19

A firm should ensure that it has access to the necessary skills and resources that it needs to measure insurance risk using its chosen methodology.

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PRU 7.1.20

When measuring its insurance risks, a firm should consider how emerging experience could be used to update its underwriting process, in particular in relation to contract terms and pricing and also its assessment of the technical provisions in the balance sheet.

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PRU 7.1.21

A firm should have the capability to measure its exposure to insurance risk on a regular basis. In deciding on the frequency of measurement, a firm should consider:

(1) the time it takes to acquire and process all necessary data;
(2) the speed at which exposures could change; and
(3) that it may need to measure its exposure to certain types of insurance risk on a daily basis (for example, weather catastrophes).

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Risk monitoring

PRU 7.1.22

A firm should provide regular and timely information on its insurance risks to the appropriate level of management. This could include providing reports on the following:

(1) a statement of the firm's profits or losses for each class of business that it underwrites (with an associated analysis of how these have arisen for any long-term insurance contracts), including a variance analysis detailing any deviations from budget or changes in the key performance indicators that are used to assess the success of its business plan for insurance;
(2) the firm's exposure to insurance risk at all relevant levels (see PRU 7.1.15 G (1)), as well as across different geographical areas and time zones (see PRU 7.1.15 G (2)), also senior management should be kept informed of the firm's total exposure to insurance risk (see PRU 7.1.15 G (3));
(3) an analysis of any internal or external trends that could influence the firm's exposure to insurance risk in the future (e.g. new weather patterns, socio-demographic changes, expense overruns etc);
(4) any new or emerging developments in claims experience (e.g. changes in the type of claims, average claim amounts or the number of similar claims);
(5) the results of any stress testing or scenario analyses;
(6) the amount and details of new business written and the amount of business that has lapsed or been cancelled;
(7) identified fraudulent claims;
(8) a watch list, detailing, for example, material/catastrophic events that could give rise to significant numbers of new claims or very large claims, contested claims, client complaints, legal and other developments;
(9) the performance of any reinsurance/risk transfer arrangements; and
(10) progress reports on matters that have previously been referred under escalation procedures (see PRU 7.1.23 G).

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PRU 7.1.23

A firm should establish and maintain procedures for the escalation of appropriate matters to the relevant level of management. Such matters may include:

(1) any significant new exposures to insurance risk, including for example any landmark rulings in the courts;
(2) a significant increase in the size or number of claims;
(3) any breaches of the limits set out in PRU 7.1.27 G and PRU 7.1.28 G, in particular senior management should be informed where any maximum limits have been breached (see PRU 7.1.29 G); and
(4) any unauthorised deviations from its insurance risk policy (including those by a broker, appointed representative or other delegated authority).

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PRU 7.1.24

A firm should regularly monitor the effectiveness of its analysis techniques for setting provisions for claims on general insurance contracts.

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PRU 7.1.25

A firm should have appropriate procedures in place to allow managers to monitor the application (and hence the effect) of its reinsurance programme. This would include, for a general insurer, procedures for monitoring how its reinsurance programme affects the gross provisions that it makes for outstanding claims (including claims that are incurred but not reported).

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Risk control

PRU 7.1.26

A firm should take appropriate action to ensure that it is not exposed to insurance risk in excess of its risk appetite. In so doing, the firm should be both reactive, responding to actual increases in exposure, and proactive, responding to potential future increases. Being proactive should involve close co-ordination between the processes of risk control, risk identification and risk measurement, as potential future exposures need to be identified and understood before effective action can be taken to control them.

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PRU 7.1.27

A firm should consider setting limits for its exposure to insurance risk, which trigger action to be taken to control exposure. Periodically these limits should be amended in the light of new information (e.g. on the expected number or size of claims). For example, limits could be set for:

(1) the firm's aggregate exposure to a single source of insurance risk or for events that may be the result of a number of different sources;
(2) the firm's exposure to specific geographic areas or any other groupings of risks whose outcomes may be positively correlated;
(3) the number of fraudulent claims;
(4) the number of very large claims that could arise;
(5) the number of unauthorised deviations from its insurance risk policy;
(6) the amount of insurance risk than can be transferred to a particular reinsurer;
(7) the level of expenses incurred in respect of each relevant business area; and
(8) the level of persistency by product line or distribution channel.

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PRU 7.1.28

A firm should also consider setting individual underwriting limits for all employees and agents that have the authority to underwrite insurance risk. This could include both monetary limits and limits on the types of risk that they can underwrite. Where individual underwriting limits are set, the firm should ensure that they are adhered to.

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PRU 7.1.29

In addition to setting some 'normal' limits for insurance risk, a firm should consider setting some maximum limits, beyond which immediate, emergency action should be taken. These maximum limits could be determined through stress testing and scenario analysis.

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PRU 7.1.30

A firm should pay close attention to the wording of its policy documentation to ensure that these wordings do not expose it to more, or higher, claims than it is expecting. In so doing, the firm should consider:

(1) whether it has adequate in-house legal resources;
(2) the need for periodic independent legal review of policy documentation;
(3) the use of standardised documentation and referral procedures for variation of terms;
(4) reviewing the documentation used by other insurance companies;
(5) revising documentation for new policies in the light of past experience; and
(6) the operation of law in the jurisdiction of the policyholder.

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PRU 7.1.31

A firm should ensure that it has appropriate systems and controls for assessing the validity of claims. This could involve consideration of the evidence that will be required from policyholders and how this evidence is to be tested as well as procedures to determine when experts such as loss adjusters, lawyers or accountants should be used.

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PRU 7.1.32

Particular care should be taken to ensure that a firm has appropriate systems and controls to deal with large claims or large groups of claims that could significantly deplete its financial resources. This should include systems to ensure that senior management (that is, the governing body and relevant senior managers) is involved in the processing of such claims from the outset.

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PRU 7.1.33

A firm should consider how it intends to use reinsurance or some other form of insurance risk transfer agreement to help to control its exposure to insurance risk. Additional guidance on the use of reinsurance/risk transfer is provided below.

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Reinsurance and other forms of risk transfer

PRU 7.1.34

Before entering into or significantly changing a reinsurance agreement, or any other form of insurance risk transfer agreement, a firm should:

(1) analyse how the proposed reinsurance/risk transfer agreement will affect its exposure to insurance risk, its underwriting strategy and its ability to meet its regulatory obligations;
(2) ensure there are adequate legal checking procedures in respect of the draft agreement;
(3) conduct an appropriate due diligence of the reinsurer's financial stability (that is, solvency) and expertise; and
(4) understand the nature and limits of the agreement (particular attention should be given to the wording of contracts to ensure that all of the required risks are covered, that the level of available cover is appropriate, and that all the terms, conditions and warranties are unambiguous and understood).

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PRU 7.1.35

In managing its reinsurance agreements, or any other form of insurance risk transfer agreement, a firm should have in place appropriate systems that allow it to maintain its desired level of cover. This could involve systems for:

(1) monitoring the risks that are covered (that is, the scope of cover) by these agreements and the level of available cover;
(2) keeping underwriting staff informed of any changes in the scope or level of cover;
(3) properly co-ordinating all reinsurance/risk transfer activities so that, in aggregate, the desired level and scope of cover is maintained;
(4) ensuring that the firm does not become overly reliant on any one reinsurer or other risk transfer provider;
(5) conducting regular stress testing and scenario analysis to assess the resilience of its reinsurance and risk transfer programmes to catastrophic events that may give rise to large and or numerous claims.

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PRU 7.1.36

In making a claim on a reinsurance contract (that is, its reinsurance recoveries) or some other risk transfer contract a firm should ensure:

(1) that it is able to identify and recover any money that it is due in a timely manner; and
(2) that it makes adequate financial provision for the risk that it is unable to recover any money that it expected to be due, as a result of either a dispute with or a default by the reinsurer/risk transfer provider. Additional guidance on credit risk in reinsurance/risk transfer contracts is provided in PRU 3.2 (Credit risk in insurance).

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PRU 7.1.37

Where the planned level or scope of cover from a reinsurance/risk transfer contract is not obtained, a firm should consider revising its underwriting strategy.

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Record keeping

PRU 7.1.38

The FSA's high level rules and guidance for record keeping are outlined in SYSC 3.2.20 R (Records). Additional rules and guidance in relation to the prudential context are set out in PRU 1.4.51 G to PRU 1.4.64G. In complying with these rules and guidance, a firm should retain an appropriate record of its insurance risk management activities. This may, for example, include records of:

(1) each new risk that is underwritten (noting that these records may be held by agents or cedants, rather than directly by the firm provided that the firm has adequate access to those records);
(2) any material aggregation of exposure to risk from a single source, or of the same kind or to the same potential catastrophe or event;
(3) each notified claim including the amounts notified and paid, precautionary notices and any re-opened claims;
(4) policy and contractual documents and any relevant representations made to policyholders;
(5) other events or circumstances relevant to determining the risks and commitments that arise out of contracts of insurance (including discretionary benefits and charges under any long-term insurance contracts);
(6) the formal wordings of reinsurance contracts; and
(7) any other relevant information on the firm's reinsurance or other risk-transfer arrangements, including the extent to which they:

(a) have been exhausted by recoveries on paid claims; and
(b) will be exhausted by recoveries on reported claims and, to the extent known, on incurred but not reported claims.

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PRU 7.1.39

A firm should retain its underwriting and claims histories for as long as they may be needed to inform pricing or provisioning decisions.

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PRU 7.2

Capital resources requirements and technical provisions for insurance business

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Application

PRU 7.2.1

PRU 7.2 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 7.2.2

(1) This section applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.
(2) Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.

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PRU 7.2.3

For a non-EEA direct insurer with a branch in the United Kingdom, the part of this section headed "Capital requirements for insurers" (PRU 7.2.43 G to PRU 7.2.91 R) applies to its world-wide activities, whilst the parts of this section headed "Establishing technical provisions" (PRU 7.2.12 R to PRU 7.2.19 G), "Assets of a value sufficient to cover technical provisions" (PRU 7.2.20 R to PRU 7.2.29 G), "Matching of assets and liabilities" (PRU 7.2.34 R to PRU 7.2.40 G) and "Premiums for new business" (PRU 7.2.41 R to PRU 7.2.42 G) apply in respect of its activities carried on from a branch in the United Kingdom. The part of this section headed "Localisation" (PRU 7.2.30 R to PRU 7.2.33 R) does not apply (see PRU 7.6 (Internal contagion risk)).

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PRU 7.2.4

For an EEA-deposit insurer or a Swiss general insurer, the parts of this section headed "Establishing technical provisions" (PRU 7.2.12 R to PRU 7.2.19 G), "Assets of a value sufficient to cover technical provisions" (PRU 7.2.20 R to PRU 7.2.29 G), "Matching of assets and liabilities" (PRU 7.2.34 R to PRU 7.2.40 G) and "Premiums for new business" (PRU 7.2.41 R to PRU 7.2.42 G) apply in respect of the activities of the firm carried on from a branch in the United Kingdom. The parts of this section headed "Capital requirements for insurers" (PRU 7.2.43 G to PRU 7.2.91 R) and "Localisation" (PRU 7.2.30 R to PRU 7.2.33 R) do not apply.

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PRU 7.2.5

For an UK-deposit insurer, the part of this section headed "Capital requirements for insurers" (PRU 7.2.43 G to PRU 7.2.91 R) applies to its world-wide activities, whilst the parts of this section headed "Establishing technical provisions" (PRU 7.2.12 R to PRU 7.2.19 G), "Assets of a value sufficient to cover technical provisions" (PRU 7.2.20 R to PRU 7.2.29 G), "Matching of assets and liabilities" (PRU 7.2.34 R to PRU 7.2.40 G) and "Premiums for new business" (PRU 7.2.41 R to PRU 7.2.42 G) apply in respect of the activities of the firm carried on from branches in EEA States. The part of this section headed "Localisation" (PRU 7.2.30 R to PRU 7.2.33 R) does not apply (see PRU 7.6 (Internal contagion risk)).

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PRU 7.2.6

This section may apply in cases where a firm has its head office in another EEA State but is neither an incoming EEA firm nor an incoming Treaty firm; this could arise in the case of a non-directive mutual or a pure reinsurer.

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Purpose

PRU 7.2.7

PRU 7.2 has the aim of reducing the risk that a firm may fail to meet its liabilities to its policyholders as a result of insurance risk, that is, the risk that arises from the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

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PRU 7.2.8

This section requires that the technical provisions that firms establish are adequate to meet their liabilities to policyholders under contracts of insurance. It also requires that firms hold assets of a value sufficient to cover their liabilities, including technical provisions, and that there is suitable matching of assets and liabilities. Technical provisions are the on-balance sheet provisions made by a firm in respect of liabilities arising under or in connection with contracts of insurance. There are different rules and guidance applicable to the calculation of technical provisions for general insurance business and for long-term insurance business.

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PRU 7.2.9

This section implements requirements of the Insurance Directives for both general insurance business and long-term insurance business with regard to the technical provisions. The relevant articles of the Directives include:

(1) article 15 of the First Non-Life Directive, as substituted by article 17 of the Third Non-Life Directive; and
(2) article 20 of the Consolidated Life Directive (this Directive consolidates the provisions of the previous First, Second and Third Life Directives).

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PRU 7.2.10

This section also sets out detailed rules and guidance on the calculation of the following elements of a firm's capital resources requirement (CRR) (see PRU 2.1):

(1) the general insurance capital requirement; and
(2) the long-term insurance capital requirement.

31/12/2004

PRU 7.2.11

These requirements are dealt with in the part of this section headed "Capital requirements for insurers" (see PRU 7.2.43 G to PRU 7.2.91 R). That part of this section also contains rules about the calculation of the insurance-related capital requirement, which forms part of the enhanced capital requirement for firms carrying on general insurance business. The asset-related capital requirement for firms carrying on general insurance business is set out in PRU 3.3.

31/12/2004

Establishing technical provisions

PRU 7.2.12

For general insurance business, a firm must establish adequate technical provisions:

(1) in accordance with the rules in PRU 7.5 for equalisation provisions; and
(2) otherwise, in accordance with PRU 1.3.5R.

31/12/2004

PRU 7.2.13

For general insurance business, the technical provisions include outstanding claims provisions, unearned premiums provisions, unexpired risk provisions and equalisation provisions. These provisions take into account the expected ultimate cost of claims, including those not yet incurred, related expenses and include an allowance for smoothing claims (the equalisation provision).

31/12/2004

PRU 7.2.14

Discounting (that is discounting for the time value of money) general insurance business technical provisions may be carried out only in limited circumstances and on a prudent basis (see PRU 2.2.80R and PRU 2.2.81R and paragraph 48 of the insurance accounts rules). The fact that the expected liabilities are generally not discounted helps to protect against risk from inherent uncertainty in the timing, but not necessarily the amount, of claims.

31/12/2004

PRU 7.2.15

For some categories of general insurance business, equalisation provisions are required. These ensure that a firm retains additional assets to provide some extra protection against uncertainty as to the amount of claims. Equalisation provisions are particularly suitable for volatile business, where claims in any future year may be subject to significant adverse deviation from recent or average expected claims experience, or where trends in claims experience may be subject to change. Such volatile claims experience arises in a number of types of business, for example, property, marine and aviation, nuclear, certain non-proportional reinsurance treaty business, and credit insurance. The equalisation provisions help to equalise fluctuations in loss ratios in future years (see PRU 7.5 (Equalisation provisions)).

31/12/2004

PRU 7.2.16

For long-term insurance business, a firm must establish adequate technical provisions:

(1) for its long-term insurance contracts, in accordance with the rules and guidance in PRU 7.3 relating to mathematical reserves, and with due regard to generally accepted actuarial practice; and
(2) for long-term insurance liabilities which have fallen due, in accordance with PRU 1.3.5R.

31/12/2004

PRU 7.2.17

Rules and guidance for calculating mathematical reserves are set out in PRU 7.3. Firms are advised by the actuarial function (see SUP 4) on the methods and assumptions to be used in calculating the mathematical reserves. The standards and guidance issued by the Faculty and Institute of Actuaries to assist actuaries appointed to the actuarial function are important sources of evidence as to generally accepted actuarial practice, as referred to in PRU 7.2.16 R (1).

31/12/2004

PRU 7.2.18

For long-term insurance business, the technical provisions include the mathematical reserves. These are actuarial estimates of a firm's liabilities in respect of future benefits due to policyholders, including bonuses already declared. The mathematical reserves may be reduced by the actuarial value of that component of future premiums attributable to meeting future liabilities (see PRU 7.3 (Mathematical reserves)).

31/12/2004

PRU 7.2.19

For long-term insurance business, the mathematical reserves are typically valued on a discounted basis but include valuation margins intended to provide protection against adverse deviations in experience (see PRU 7.3).

31/12/2004

Assets of a value sufficient to cover technical provisions

PRU 7.2.20

A firm must hold admissible assets of a value at least equal to the amount of the technical provisions that it is required to establish under PRU 7.2.12 R and PRU 7.2.16 R (excluding technical provisions for property-linked and index-linked benefits and the assets held to cover them under PRU 4.2.57R and PRU 4.2.58R).

31/12/2004

PRU 7.2.21

A composite firm must ensure that:

(1) its separately identified long-term insurance assets have a value at least equal to the amount of:

(a) its technical provisions for long-term insurance liabilities; and
(b) any other liabilities connected with long-term insurance business; and

(2) that it has other admissible assets of a value at least equal to the amount of its technical provisions for general insurance liabilities.

31/12/2004

PRU 7.2.22

PRU 7.6 (Internal-contagion risk) sets out the rules and guidance on identifying and holding in a separate fund long-term insurance assets.

31/12/2004

PRU 7.2.23

When valuing assets for the purposes of PRU 7.2.20 R and PRU 7.2.21 R, a firm should bear in mind:

(1) that the technical provisions should be covered by admissible assets (see PRU 2 Annex 1 RR); and
(2) the market and counterparty limits set out in PRU 3.2 (Credit risk in insurance). PRU 3.2 requires that a firm restrict to prudent levels its exposure to reinsurer and other counterparties, and, in particular, that for the purpose of its balance sheet, a firm must not take into account any exposure which exceeds the large exposure limits.

31/12/2004

PRU 7.2.24

Rules and guidance on the valuation of assets are set out in PRU 1.3 (Valuation), including the treatment of shares in, and debts due from, related undertakings in PRU 1.3.31R to PRU 1.3.42 G. PRU 4.2 (Market risk in insurance) addresses market risk and sets out the matching requirements for linked assets and liabilities. PRU 4.2 also sets out rules and guidance on the matching by currency of assets and liabilities, to reduce a firm's exposure to currency market risk.

31/12/2004

PRU 7.2.25

For the purpose of determining the value of assets available to meet long-term insurance liabilities in accordance with PRU 7.2.20 R, PRU 7.2.21 R, PRU 7.2.27 R and PRU 7.2.28 R, no value is to be attributed to debts and claims other than in respect of:

(1) amounts that have already fallen due;
(2) tax recoveries and claims against compensation funds to the extent not already offset in mathematical reserves.

31/12/2004

PRU 7.2.26

Certain debts and claims are excluded from PRU 7.2.20 R, PRU 7.2.21 R, PRU 7.2.27 R and PRU 7.2.28 R to avoid double-counting. The rules and guidance in PRU 7.3 (Mathematical reserves) set out how a firm may offset debts and claims against liabilities in calculating the mathematical reserves required for long-term insurance business. Tax recoveries and claims against compensation funds in PRU 7.2.25 R (2) are set out in the list of admissible assets (see PRU 2 Annex 1R).

31/12/2004

PRU 7.2.27

A firm carrying on long-term insurance business must ensure that it has admissible assets in each of its with-profits funds of a value sufficient to cover the technical provisions in respect of all the business written in that with-profits fund.

31/12/2004

PRU 7.2.28

In addition to complying with PRU 7.2.27 R, a realistic basis life firm must also ensure that the realistic value of assets for each of its with-profits funds is at least equal to the realistic value of liabilities of that fund.

31/12/2004

PRU 7.2.29

PRU 7.2.27 R and PRU 7.2.28 R support the funding of policyholder benefits by requiring firms to maintain admissible assets in with-profits funds to cover the technical provisions relating to all the business in that fund and, in the case of a realistic basis life firm, realistic assets to cover the realistic liabilities of the with-profits insurance contracts written in the fund.

31/12/2004

Localisation (UK firms only)

PRU 7.2.30

(1) Subject to (2), a UK firm must hold admissible assets held pursuant to PRU 4.2.53R:

(a) (where the admissible assets cover technical provisions in pounds sterling), in any EEA State; and
(b) (where the admissible assets cover technical provisions in any currency other than pounds sterling), in any EEA State or in the country of that currency.

(2) In the case of a community co-insurance operation and a relevant insurer, the admissible assets covering technical provisions must be held in any EEA State.

31/12/2004

PRU 7.2.31

PRU 7.6 (Internal contagion risk) sets out the rules and guidance on localisation for firms other than UK firms.

31/12/2004

PRU 7.2.32

PRU 7.2.30 R does not apply to:

(1) a pure reinsurer; or
(2) debts owed by reinsurers; or
(3) insurance business carried on by a UK firm outside the EEA States; or
(4) general insurance business class groups 3 and 4 in IPRU(Ins), Annex 11.2, Part II.

31/12/2004

PRU 7.2.33

For the purposes of PRU 7.2.30 R:

(1) a tangible asset is to be treated as held in the country or territory where it is situated;
(2) an admissible asset consisting of a claim against a debtor is to be treated as held in any country or territory where it can be enforced by legal action;
(3) a listed security is to be treated as held in any country or territory where there is a regulated market on which the security is dealt; and
(4) a security which is not a listed security is to be treated as held in the country or territory in which the issuer has its head office.

31/12/2004

Matching of assets and liabilities

PRU 7.2.34

(1) Subject to (4), the assets held by a firm to cover its technical provisions (see PRU 7.2.20 R and PRU 7.2.21 R) must:

(a) have characteristics of safety, yield and marketability which are appropriate to the type of business carried on by the firm;
(b) be diversified and adequately spread; and
(c) comply with (2).

(2) The assets referred to in (1) must, in addition to meeting the criteria set out in (1)(a) and (b), be of a sufficient amount, and of an appropriate currency and term, to ensure that the cash inflows from those assets will meet the expected cash outflows from the firm's insurance liabilities as they become due.
(3) For the purpose of (2), a firm must take into consideration in determining expected cash outflows any options which exist in the firm's contracts of insurance.
(4) (1) does not apply to assets held to cover index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, (1) will nevertheless apply to assets held to cover that guaranteed element.

31/12/2004

PRU 7.2.35

A firm should take account of the amount, currency and timing of its expected cash outflows in determining whether the assets it holds to cover its technical provisions meet the requirements of PRU 7.2.34 R (2).

31/12/2004

PRU 7.2.36

For the purpose of PRU 7.2.34 R (2), the relevant cash inflows are those which the firm reasonably expects to receive from the admissible assets which it holds to cover its technical provisions. A firm may receive cash inflows as a result of:

(1) selling assets or closing out transactions;
(2) holding assets that generate dividends, interest or other income; and
(3) receiving future premiums for existing business.

31/12/2004

PRU 7.2.37

Anticipated cash inflows from future new business should not be included, for example where the customer has not yet contracted to pay the premium, and where the associated liabilities and potential cash outflows should also not be included.

31/12/2004

PRU 7.2.38

A firm should compare cash inflows and outflows based on current expectations of amounts and timings. Current market expectations of future asset values, interest rates and currency exchange rates should be used. Where inflows are received in a currency different from that in which outflows are to be paid, account should be taken of the cost of converting the currency received.

31/12/2004

PRU 7.2.39

In considering the value and suitability of assets required to ensure that the firm's liabilities are met as they become due, a firm should take account of the risk of default on inflows from those assets, and other risks that may mean that future inflows are reduced relative to outflows.

31/12/2004

PRU 7.2.40

PRU 7.2.20 R lays down a general requirement for a firm that carries on long-term insurance business to hold admissible assets that are of a value sufficient to cover its mathematical reserves (calculated in accordance with the rules in PRU 7.3). The PRU 7.2.34 R (2) requirement to match liabilities with assets that allow cash outflows to be met with suitable inflows as the outflows become due may mean that a firm has to hold assets of a value greater than would otherwise be required by the general rule in PRU 7.2.20 R.

31/12/2004

Premiums for new business

PRU 7.2.41

A firm must not enter into a long-term insurance contract unless it is satisfied on reasonable actuarial assumptions that:

(1) the premiums receivable and the investment income expected to be earned from those premiums; and
(2) the reinsurance arrangements made in respect of the risk or risks covered by that new contract;
are sufficient to enable it, when taken together with the firm's other resources, to:

(a) establish adequate technical provisions as required by PRU 7.2.16 R;
(b) hold admissible assets of a value at least equal to the amount of the technical provisions as required by PRU 7.2.20 R to PRU 7.2.28 R; and
(c) maintain adequate overall financial resources as required by PRU 1.2.22R.

31/12/2004

PRU 7.2.42

For the purposes of PRU 7.2.41 R, the adequacy of premiums may be assessed in the context of a firm's total portfolio of business and its other resources. It thus does not prevent a firm writing loss leaders nor writing contracts which might incur large losses, but only if the firm can meet the losses that might reasonably arise, including those that would arise from an event specifically insured against.

31/12/2004

Capital requirements for insurers

PRU 7.2.43

(1) PRU 2.1.9R requires a firm to maintain capital resources equal to or in excess of its capital resources requirement (CRR). PRU 2.1 sets out the overall framework of the CRR; in particular, PRU 2.1.14 R requires that for a firm carrying on general insurance business the CRR is equal to the minimum capital requirement (MCR). PRU 2.1.15 R requires that for realistic basis life firms the CRR is the higher of the MCR and the ECR. PRU 2.1.20 R requires that for regulatory basis only life firms the CRR is equal to the MCR.
(2) For non-life firms the MCR represents the minimum capital requirement (or margin of solvency) prescribed by the Insurance Directives. PRU 2.1.21 R provides that, for a firm carrying on general insurance business, the MCR in respect of that business is the higher of the base capital resources requirement for general insurance business applicable to that firm and the general insurance capital requirement. PRU 2.1.22 R provides that, for a firm carrying on long-term insurance business, the MCR in respect of that business is the higher of the base capital resources requirement for long-term insurance business applicable to that firm and the sum of the long-term insurance capital requirement and the resilience capital requirement. As specified in PRU 2.1.10 R, a firm carrying on both general insurance business and long-term insurance business must apply PRU 2.1.9R (referred to in paragraph (1) above) separately to its general insurance business and its long-term insurance business.
(3) The calculation of the general insurance capital requirement is set out in PRU 7.2.44 G to PRU 7.2.72 R below. PRU 7.2.73 G to PRU 7.2.79 R set out the calculation of the insurance-related capital requirement for non-life firms. The calculation of the long-term insurance capital requirement is set out in PRU 7.2.80 G to PRU 7.2.91 R below.

31/12/2004

General insurance capital requirement

PRU 7.2.44

In relation to the MCR (see PRU 7.2.43 G), PRU 2.1.30 R requires a firm to calculate its general insurance capital requirement (GICR) as the highest of the premiums amount, the claims amount, and the brought forward amount. The elements for this computation are set out in PRU 7.2 as follows:

(1) the premiums amount in PRU 7.2.45 R;
(2) the claims amount in PRU 7.2.47 R; and
(3) the brought forward amount in PRU 7.2.51 R.

31/12/2004

The premiums amount

PRU 7.2.45

The premiums amount is:

(1) 18% of the gross adjusted premiums amount; less 2% of the amount, if any, by which the gross adjusted premiums amount exceeds €50 million; multiplied by
(2) the reinsurance ratio set out in PRU 7.2.54 R.

31/12/2004

PRU 7.2.46

Rules and guidance as to how the gross adjusted premiums amount is to be calculated are set out in PRU 7.2.56 R to PRU 7.2.59 G.

31/12/2004

The claims amount

PRU 7.2.47

The claims amount is:

(1) 26% of the gross adjusted claims amount; less 3% of the amount, if any, by which the gross adjusted claims amount exceeds € 35 million; multiplied by
(2) the reinsurance ratio set out in PRU 7.2.54 R.

31/12/2004

PRU 7.2.48

Rules and guidance as to how the gross adjusted claims amount is to be calculated are set out in PRU 7.2.60 R to PRU 7.2.65 G.

31/12/2004

PRU 7.2.49

(1) Subject to (2) and (3), the Euro amounts specified in PRU 7.2.45 R (1) and PRU 7.2.47 R (1) will increase each year, starting on the first review date of 20 September 2005 (and annually after that), by the percentage change in the European index of consumer prices (comprising all European Union member states, as published by Eurostat) from 20 March 2002 to the relevant review date, rounded up to a multiple of €100,000.
(2) In any year, if the percentage change since the last increase is less than 5%, then there will be no increase.
(3) The increase will take effect 30 days after the EU Commission has informed the European Parliament and Council of its review and the relevant percentage change.

31/12/2004

PRU 7.2.50

For the purposes of PRU 7.2.45 R (1) and PRU 7.2.47 R (1), the exchange rate from the Euro to the pound sterling for each year beginning on 31 December is the rate applicable on the last day of the preceding October for which the exchange rates for the currencies of all the European Union member states were published in the Official Journal of the European Union.

31/12/2004

The brought forward amount

PRU 7.2.51

The brought forward amount is the general insurance capital requirement (GICR) for the prior financial year, multiplied, if the ratio is less than one, by the ratio (expressed as a percentage) of:

(1) the technical provisions (calculated net of reinsurance) for claims outstanding at the end of the prior financial year, determined in accordance with PRU 7.2.12 R; to
(2) the technical provisions (calculated net of reinsurance) for claims outstanding at the beginning of the prior financial year, determined in accordance with PRU 7.2.12 R.

31/12/2004

PRU 7.2.52

The brought forward amount is the same as the GICR for the prior financial year, except where claims outstanding have fallen during that financial year. If they have fallen, the brought forward amount is itself reduced by the same percentage fall.

31/12/2004

PRU 7.2.53

If the GICR for the prior financial year is less than the premiums amount or the claims amount, then a brought forward amount is not required to be calculated.

31/12/2004

Reinsurance ratio used in calculating the premiums amount and the claims amount

PRU 7.2.54

The reinsurance ratio referred to in PRU 7.2.45 R (2) and PRU 7.2.47 R (2) is:

(1) if the ratio lies between 50% and 100%, the ratio (expressed as a percentage) of:

(a) the claims incurred (net of reinsurance) in the financial year in question and the two previous financial years; to
(b) the gross claims incurred in that three-year period;

(2) 50%, if the ratio calculated in (a) and (b) of (1) is 50% or less; and
(3) 100%, if the ratio calculated in (a) and (b) of (1) is 100% or more.

31/12/2004

PRU 7.2.55

Rules and guidance as to how the net and gross claims are to be calculated are set out in PRU 7.2.66 R to PRU 7.2.71 R.

31/12/2004

Gross adjusted premiums amount used in calculating the premiums amount

PRU 7.2.56

For the purpose of PRU 7.2.45 R, the gross adjusted premiums amount is the higher of the written and earned gross premiums (as determined in accordance with PRU 7.2.66 R) for the financial year in question, adjusted by:

(1) except for a pure reinsurer that does not have permission under the Act to effect contracts of insurance, increasing by 50% the amount included in respect of the premiums for general insurance business classes 11, 12 and 13;
(2) deducting 66.7% of the premiums for actuarial health insurance that meets the conditions set out in PRU 7.2.72 R; and
(3) multiplying the resulting figure by 12 and dividing by the number of months in the financial year. For the purposes of this calculation, the number of months in the financial year is the number of complete calendar months in the financial year plus any fractions of a month at the beginning and the end of the financial year.

31/12/2004

PRU 7.2.57

A firm may use statistical methods in order to allocate premiums in respect of the classes 11, 12 and 13 for the purposes of PRU 7.2.56 R.

31/12/2004

PRU 7.2.58

General insurance business classes 11, 12 and 13 are, respectively, the marine liability, aviation liability and general liability insurance classes.

31/12/2004

PRU 7.2.59

Where the firm did not carry on insurance business in the financial year in question, the gross adjusted premiums amount, and therefore the premiums amount, is nil.

31/12/2004

Gross adjusted claims amount used in calculating the claims amount

PRU 7.2.60

For the purpose of PRU 7.2.47 R and subject to PRU 7.2.62 R, the gross adjusted claims amount is the amount of gross claims incurred (as determined in accordance with PRU 7.2.66 R) over the reference period (as specified in PRU 7.2.63 R) and adjusted by:

(1) except for a pure reinsurer that does not have permission under the Act to effect contracts of insurance, increasing by 50% the amount included in respect of the claims incurred for general insurance business classes 11, 12 and 13;
(2) deducting 66.7% of the claims for actuarial health insurance that meets the conditions set out in PRU 7.2.72 R; and
(3) multiplying the resulting figure by 12 and dividing by the number of months in the reference period. For the purposes of this calculation, the number of months in the reference period is the number of complete calendar months in the reference period plus any fractions of a month at the beginning and the end of the reference period.

31/12/2004

PRU 7.2.61

A firm may use statistical methods in order to allocate claims in respect of classes 11, 12 and 13 for the purposes of PRU 7.2.60 R.

31/12/2004

PRU 7.2.62

For the purposes of PRU 7.2.47 R, in relation to general insurance business class 18, the amount of claims incurred used to calculate the gross adjusted claims amount must be the amount of costs recorded in the firm's books in the reference period as borne by the firm (whether or not borne in the reference period) in respect of the assistance given.

31/12/2004

PRU 7.2.63

(1) Except in those cases where paragraph (2) applies, the reference period to be used in PRU 7.2.60 R and PRU 7.2.62 R must be:

(a) the financial year in question and the two previous financial years; or
(b) the period the firm had been in existence at the end of the financial year in question, if shorter.

(2) In the case of a firm which underwrites only one or more of the general insurance business risks of credit, storm, hail or frost (including other business written in connection with such risks), the reference period to be used must be:

(a) the financial year in question and the six previous financial years; or
(b) the period the firm had been in existence at the end of the financial year in question, if shorter.

31/12/2004

PRU 7.2.64

The classification of the risks referred to in PRU 7.2.63 R (2) is as follows: credit - as included in general insurance business class 14; storm - as included in general insurance business class 8; hail - as included in general insurance business class 9; and frost - as included in general insurance business class 9.

31/12/2004

PRU 7.2.65

Where the firm did not carry on insurance business in the reference period, the gross adjusted claims amount, and therefore the claims amount, is nil.

31/12/2004

Accounting for premiums and claims

PRU 7.2.66

For the purposes of PRU 7.2.54 R, PRU 7.2.56 R, PRU 7.2.60 R and PRU 7.2.62 R, amounts of premiums and claims must be:

(1) determined in accordance with PRU 1.3 (Valuation); and
(2) adjusted for transfers that were approved by the relevant authority (or became effective where approval by an authority was not required) before the end of the financial year in question:

(a) to exclude any amount included in, or adjustment made to, premiums and claims to reflect the consideration for a transfer of contracts of insurance to or from the firm;
(b) to exclude premiums and claims which arose from contracts of insurance that have been transferred by the firm to another body; and
(c) to account for premiums and claims which arose from contracts of insurance that have been transferred to the firm from another body as if they were receivable by or payable to the firm.

31/12/2004

PRU 7.2.67

To ensure that all rights and obligations under a contract of insurance are transferred, a number of alternative mechanisms could be used. These are: an insurance business transfer under Part VII of the Act; under earlier United Kingdom insurance legislation; under equivalent foreign legislation; or by novation of contracts. The term "relevant authority" in paragraph (2) of PRU 7.2.66 R may refer to whatever body has responsibility in a country, whether within or outside the EEA, for the approval of transfers of portfolios of contracts of insurance; the body may be a supervisory authority for financial services as such or it may be a judicial authority which has the necessary responsibility.

31/12/2004

PRU 7.2.68

PRU 7.2.66 R (2)(b) requires a firm, for the purpose of calculating its GICR, to account for contracts of insurance transferred by it to another body as if it had never written those contracts. All amounts of premiums and claims arising in respect of those contracts are excluded, including amounts that arose in the financial year in question or previous financial years.

31/12/2004

PRU 7.2.69

Conversely, PRU 7.2.66 R (2)(c) requires a firm, for the purpose of calculating its GICR, to account for contracts of insurance transferred to it by another body as if it had been responsible for those contracts from inception and not merely from the date of transfer. All amounts of premiums and claims that arose from those contracts are included even where they arose prior to the date of transfer and were, in fact, receivable by or payable to the other body.

31/12/2004

PRU 7.2.70

For both transfers to and from the firm, the consideration receivable or payable in respect of the transfer is excluded from premiums and claims in order to avoid double counting.

31/12/2004

PRU 7.2.71

Where there has been a significant change in the business portfolio of the firm since the end of the financial year in question, for example, a line of business has been transferred to another firm, or the firm no longer carries on a particular class of insurance business, the gross adjusted premiums amount and the gross adjusted claims amount must both be recalculated to take into account the impact of this change. The recalculation must take into account the requirements of PRU 1.3 (Valuation).

31/12/2004

Actuarial health insurance

PRU 7.2.72

The conditions referred to in PRU 7.2.56 R (2) and PRU 7.2.60 R (2) are that:

(1) the health insurance is underwritten on a similar technical basis to that of life insurance;
(2) the premiums paid are calculated on the basis of sickness tables according to the mathematical method applied in insurance;
(3) a provision is set up for increasing age;
(4) an additional premium is collected in order to set up a safety margin of an appropriate amount;
(5) it is not possible for the firm to cancel the contract after the end of the third year of insurance; and
(6) the contract provides for the possibility of increasing premiums or reducing payments even for current contracts.

31/12/2004

Insurance-related capital requirement (general insurance business only)

PRU 7.2.73

PRU 2.3.11 R requires firms carrying on general insurance business, other than a non-directive insurer, to calculate their ECR as the sum of the asset-related capital requirement and the insurance-related capital requirement less the firm's equalisation provisions. The ECR for firms carrying on general insurance business is an indicative measure of the capital resources that a firm may need to hold based on risk sensitive calculations applied to its business profile. For firms carrying on general insurance business, the FSA will use the ECR as a benchmark for individual capital guidance for a firm carrying on general insurance business. Details of the calculation of the asset-related capital requirement are set out in PRU 3.3. Details of the calculation of the insurance-related capital requirement are set out in PRU 7.2.76 R to PRU 7.2.79 R.

31/12/2004

PRU 7.2.74

The insurance-related capital requirement is a measure of the capital that a firm should hold against the risk of:

(1) an adverse movement in the value of a firm's liabilities, to recognise that there may be substantial volatility in claims and other technical provisions made by the firm. Such variations may be due to inflationary increases, interest rate changes, movements in the underlying provisions themselves, changes in expense costs, inadequate rate pricing or premium collections (or both) from intermediaries differing from projected assumptions; and
(2) the premiums a firm charges in respect of particular business not being adequate to fund future liabilities arising from that business.

31/12/2004

PRU 7.2.75

The insurance-related capital requirement is calculated by applying capital charge factors, expressed as a percentage, to the value of the net written premiums and the technical provisions in respect of different classes of business. Firms should refer to PRU 1.3.5 R which sets out how a firm must recognise and value assets and liabilities.

31/12/2004

Calculation of the insurance-related capital requirement

PRU 7.2.76

A firm must calculate its insurance-related capital requirement in accordance with PRU 7.2.77 R.

31/12/2004

PRU 7.2.77

(1) The value of:

(a) the net written premiums; and
(b) the technical provisions;

in respect of each class of business listed in the table in PRU 7.2.79 R must be multiplied by the corresponding capital charge factor.
(2) If any amount which is to be multiplied by a capital charge factor is a negative amount, that amount shall be treated as zero.
(3) The amounts resulting from multiplying the net written premiums in respect of each such class of business by the corresponding capital charge factor must be aggregated.
(4) The amounts resulting from multiplying the technical provisions in respect of each such class of business by the corresponding capital charge factor must be aggregated.
(5) The insurance-related capital requirement is the sum of the amounts calculated in accordance with (3) and (4).

31/12/2004

PRU 7.2.78

In PRU 7.2.77 R references to technical provisions comprise:

(1) outstanding claims;
(2) provisions for incurred but not reported (IBNR) claims;
(3) provisions for incurred but not enough reported (IBNER) claims;
(4) unearned premium reserves less deferred acquisition costs; and
(5) unexpired risk reserves;

in each case net of reinsurance receivables.

31/12/2004

PRU 7.2.79

Table: Insurance-related Capital Charge Factors

Class of Business

Net Written Premium capital charge factor

Technical provision capital charge factor

Reporting Group: Direct Personal Motor

Private motor - comprehensive

10.0%

9.0%

Private motor - non-comprehensive

10.0%

9.0%

Motor cycle

10.0%

9.0%

Reporting Group: Direct Commercial Motor

Fleets

10.0%

9.0%

Commercial vehicles (non-fleet)

10.0%

9.0%

Reporting Group: Direct Accident & Health

Private medical insurance

5.0%

7.5%

HealthCare cash plans

5.0%

7.5%

Personal accident or sickness

5.0%

7.5%

Travel

5.0%

7.5%

Reporting Group: Direct Personal Lines Property

Household and domestic all risks

10.0%

Reporting Group: Direct Personal Lines Pecuniary Loss

Assistance

25.0%

14.0%

Creditor

25.0%

14.0%

Extended warranty

25.0%

14.0%

Legal expenses

25.0%

14.0%

Reporting Group: Direct Commercial Lines Property

Commercial property damage and theft

10.0%

Engineering all risks

10.0%

Contractors all risks

10.0%

Energy

10.0%

Mixed commercial package

10.0%

Reporting Group: Direct Commercial Lines Liability

Employers liability

14.0%

Product liability

14.0%

Public liability

14.0%

Professional indemnity

14.0%

Reporting Group: Direct Commercial Lines Pecuniary Loss

Fidelity and contract guarantee

25.0%

14.0%

Mortgage indemnity

25.0%

14.0%

Credit

25.0%

14.0%

Consequential loss

25.0%

14.0%

Suretyship

25.0%

14.0%

Reporting Group: Direct Aviation

Aviation liability

32.0%

14.0%

Aviation hull

32.0%

14.0%

Space and satellite

32.0%

14.0%

Reporting Group: Direct Marine

Marine liability

22.0%

17.0%

Marine hull

22.0%

17.0%

Yacht

22.0%

17.0%

War risks

22.0%

17.0%

Protection and Indemnity

22.0%

17.0%

Freight demurrage and defence

22.0%

17.0%

Reporting Group: Direct Transport

Goods in transit

12.0%

14.0%

Reporting Group: Direct Miscellaneous

Miscellaneous direct business

25.0%

14.0%

Reporting Group: Non-Proportional Treaty

Non-proportional accident & health

35.0%

16.0%

Non-proportional motor

10.0%

14.0%

Non-proportional transport

16.0%

15.0%

Non-proportional aviation

61.0%

16.0%

Non-proportional marine

38.0%

17.0%

Non-proportional property non-catastrophe

53.0%

12.0%

Non-proportional property catastrophe

53.0%

12.0%

Non-proportional liability (non-motor)

14.0%

Non-proportional pecuniary loss

39.0%

14.0%

Non-proportional aggregate cover

53.0%

12.0%

Reporting Group: Proportional Treaty

Proportional assumed accident & health

12.0%

16.0%

Proportional assumed motor

10.0%

12.0%

Proportional transport

12.0%

15.0%

Proportional aviation

33.0%

16.0%

Proportional marine

22.0%

17.0%

Proportional property

23.0%

12.0%

Proportional liability (non-motor)

14.0%

Proportional pecuniary loss

25.0%

14.0%

Proportional aggregate cover

23.0%

12.0%

Reporting Group: Facultative Reinsurance Categories

Facultative accident & health

5.0%

7.5%

Facultative motor

10.0%

9.0%

Facultative personal property

10.0%

Facultative personal financial loss

25.0%

14.0%

Facultative commercial property

10.0%

Facultative commercial liability

14.0%

Facultative commercial financial loss

25.0%

14.0%

Facultative marine

22.0%

17.0%

Facultative aviation

32.0%

14.0%

Facultative transport

12.0%

14.0%

Reporting Group: Miscellaneous Reinsurance

Miscellaneous reinsurance accepted business

39.0%

14.0%

31/12/2004

Long-term insurance capital requirement

PRU 7.2.80

PRU 2.1.9 R requires a firm to which PRU 2 applies to maintain capital resources equal to or in excess of its capital resources requirement. PRU 2.1.15 R defines the capital resources requirement for a firm to which that rule applies (a realistic basis life firm) as the higher of the MCR and the ECR. For other firms carrying on long-term insurance business (regulatory basis only life firms), the capital resources requirement is equal to the MCR. The MCR is defined as the higher of the base capital resources requirement and the sum of the long-term insurance capital requirement (LTICR) and the resilience capital requirement (see PRU 2.1.22 R). PRU 2.1.32 R defines the LTICR as the sum of the insurance death, health, expense, and market risk capital components (see PRU 7.2.81 R to PRU 7.2.91 R). Rules and guidance about the resilience capital requirement are set out in PRU 4.2.9 G to PRU 4.2.26 R.

31/12/2004

Insurance death risk capital component

PRU 7.2.81

The insurance death risk capital component is the aggregate of the amounts which represent the fractions specified by PRU 7.2.82 R of the capital at risk, defined in PRU 7.2.83 R, for those contracts where the capital at risk is not a negative figure, multiplied by the higher of:

(1) 50%; and
(2) the ratio as at the end of the preceding financial year of:

(a) the aggregate capital at risk net of reinsurance cessions; to
(b) the aggregate capital at risk gross of reinsurance cessions.

31/12/2004

PRU 7.2.82

For the purpose of PRU 7.2.81 R, the fraction is:

(1) for long-term insurance business classes I, II and IX, except for a pure reinsurer:

(a) 0.1% for temporary insurance on death where the original term of the contract is three years or less;
(b) 0.15% for temporary insurance on death where the original term of the contract is five years or less but more than three years; and
(c) 0.3% in any other case;

(2) 0.3% for long-term insurance business classes III, VII and VIII, except for a pure reinsurer; and
(3) 0.1% for a pure reinsurer.

31/12/2004

PRU 7.2.83

For the purpose of PRU 7.2.81 R, the capital at risk is:

(1) where the benefit under a contract of insurance payable as a result of death includes periodic or deferred payments, the present value of the benefits payable; and
(2) in any other case, the amount payable as a result of death;

less, in either case, the mathematical reserves for the contract.

31/12/2004

PRU 7.2.84

The insurance death risk capital component only relates to the risk of death. There is a separate risk component for insured health risks (class IV). Tontines (class V) and capital redemption operations (class VI) also have separate risk components. There is no specified risk margin for other insured risks.

31/12/2004

Insurance health risk capital component

PRU 7.2.85

The insurance health risk capital component is the highest of:

(1) the premiums amount (determined in accordance with PRU 7.2.45 R);
(2) the claims amount (determined in accordance with PRU 7.2.47 R); and
(3) the brought forward amount (determined in accordance with PRU 7.2.51 R);
in respect of:

(a) contracts of insurance falling in long-term insurance business class IV (see PRU 7.2.86 R); and
(b) risks falling in general insurance business classes 1 or 2 that are written as part of a long-term insurance contract.

31/12/2004

PRU 7.2.86

For the purposes of PRU 7.2.85 R, in the case of contracts of insurance falling in long-term insurance business class IV, condition (3) as set out in PRU 7.2.72 R (Actuarial health insurance) is modified to: "either the reserves include a provision for increasing age, or the business is conducted on a group basis.".

31/12/2004

PRU 7.2.87

The insurance health risk capital component only arises for permanent health insurance (long-term insurance business class IV) and accident and sickness insurance (general insurance business classes 1 and 2).

31/12/2004

Insurance expense risk capital component

PRU 7.2.88

The insurance expense risk capital component is:

(1) in respect of long-term insurance business classes III, VII and VIII, an amount equivalent to 25% of the net administrative expenses in the preceding financial year relevant to the business of each of those classes, in so far as the firm bears no investment risk and the allocation to cover management expenses in the contract of insurance does not have a fixed upper limit which is effective as a limit for a period exceeding 5 years from the commencement of the contract;
(2) in respect of any tontine (long-term insurance business class V), 1% of the assets of the tontine;
(3) in the case of any other long-term insurance business, 1% of the "adjusted mathematical reserves" (as defined in PRU 7.2.90 R and PRU 7.2.91 R).

31/12/2004

Insurance market risk capital component

PRU 7.2.89

The insurance market risk capital component is 3% of the "adjusted mathematical reserves" (as defined in PRU 7.2.90 R and PRU 7.2.91 R) for all contracts of insurance except those which:

(1) fall in long-term insurance business classes III, VII or VIII and in respect of which the firm does not bear any investment risk; or
(2) fall in long-term insurance business class V.

31/12/2004

PRU 7.2.90

For the purpose of PRU 7.2.88 R and PRU 7.2.89 R, the "adjusted mathematical reserves" is the amount of mathematical reserves (gross of reinsurance cessions), multiplied by the higher of:

(1) 85% or, in the case of a pure reinsurer, 50%; and
(2) the ratio as at the end of the preceding financial year of:

(a) the mathematical reserves net of reinsurance cessions; to
(b) the mathematical reserves gross of reinsurance cessions.

31/12/2004

PRU 7.2.91

The "adjusted mathematical reserves" do not include:

(1) for the purposes of PRU 7.2.88 R (3) and PRU 7.2.89 R, amounts arising from tontines (long-term insurance business class V);
(2) for the purposes of PRU 7.2.88 R (3), amounts arising from insurance business in classes III, VII or VIII, to the extent that such business meets the conditions in PRU 7.2.88 R (1);
(3) for the purposes of PRU 7.2.89 R, amounts arising from insurance business in classes III, VII or VIII, to the extent that such business meets the conditions in PRU 7.2.89 R (1).

31/12/2004

PRU 7.3

Mathematical reserves

31/12/2004

Application

PRU 7.3.1

PRU 7.3 applies to a long-term insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

31/12/2004

Purpose

PRU 7.3.2

This section follows on from the overall requirement on firms to establish adequate technical provisions (see PRU 7.2.16 R). The mathematical reserves form the main component of technical provisions for long-term insurance business. PRU 7.3 sets out rules and guidance as to the methods and assumptions to be used in calculating the mathematical reserves. The rules and guidance set out the minimum basis for mathematical reserves. Methods and assumptions that produce reserves that are demonstrably equal to or greater than the minimum basis may also be used, though they must meet the basic requirements for methods and assumptions set out in PRU 7.3.7 R to PRU 7.3.27 G.

31/12/2004

PRU 7.3.3

This section applies to all firms carrying on long-term insurance business and implements some of the requirements contained in article 20 of the Consolidated Life Directive. The implementation is designed to ensure that a firm's mathematical reserves in respect of long-term insurance contracts meet the minimum requirements set by the Consolidated Life Directive. A firm may use a prospective or a retrospective method to value its mathematical reserves(see PRU 7.3.7 R).

31/12/2004

PRU 7.3.4

The required procedures are summarised in the flowchart in PRU 7 Annex 1G.

31/12/2004

PRU 7.3.5

Firms to which PRU 2.1.15R applies are required to calculate a with-profits insurance capital component (see PRU 2.1.34 R). In order to calculate its with-profits insurance capital component, such a firm is required to carry out additional calculations of its liabilities on a realistic basis (see PRU 7.4), which it is required to report to the FSA (see Forms 18,19). A firm that reports its liabilities on a realistic basis is referred to in PRU as a realistic basis life firm. Such firms are subject to different rules relating to the calculation of mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R) compared with those that apply to firms that report on a regulatory basis only (regulatory basis only life firms).

31/12/2004

PRU 7.3.6

A number of the rules in this section require a firm to take into account its regulatory duty to treat customers fairly. In this section, references to such a duty are to a firm's duty to pay due regard to the interests of its customers and to treat them fairly (see Principle 6 in PRIN). This duty is owed to both policyholders and potential policyholders.

31/12/2004

Basic valuation method

PRU 7.3.7

(1) Subject to (2), a firm must establish its mathematical reserves using a prospective actuarial valuation on prudent assumptions of all future cash flows expected to arise under, or in respect of, each of its long-term insurance contracts.
(2) But a firm may use a retrospective actuarial valuation where:

(a) a prospective method cannot be applied to a particular type of contract; or
(b) the firm can demonstrate that the resulting amount of the mathematical reserves would be no lower than would be required by a prudent prospective actuarial valuation.

31/12/2004

PRU 7.3.8

A prospective valuation sets the mathematical reserves at the present value of future net cash flows. A retrospective method typically sets the mathematical reserves at the level of premiums received (and accumulated with investment return), less claims and expenses paid. A prospective valuation is preferred because it takes account of circumstances that might have arisen since the premium rate was set and of changes in the perception of future experience. Circumstances in which a retrospective valuation might be appropriate include:

(1) where the assumptions initially made in determining the premium rate were sufficiently prudent at inception and have not been overtaken by subsequent events; and
(2) where the liability depends on the emerging experience.

31/12/2004

PRU 7.3.9

Except in PRU 7.3.71 R (1), PRU 7.3 does not apply to final bonuses. In addition, for realistic basis life firms only, PRU 7.3 does not apply to future annual bonuses.

31/12/2004

Methods and assumptions

PRU 7.3.10

In the actuarial valuation under PRU 7.3.7 R, a firm must use methods and prudent assumptions which:

(1) are appropriate to the business of the firm;
(2) are consistent from year to year without arbitrary changes (see PRU 7.3.11 G);
(3) are consistent with the method of valuing assets (see PRU 1.3);
(4) include appropriate margins for adverse deviation of relevant factors (see PRU 7.3.12 G);
(5) recognise the distribution of profits (that is, emerging surplus) in an appropriate way over the duration of each contract of insurance;
(6) take into account its regulatory duty to treat its customers fairly (see Principle 6); and
(7) are in accordance with generally accepted actuarial practice.

31/12/2004

PRU 7.3.11

PRU 7.3.10 R (2) prohibits only arbitrary changes in methods and assumptions, that is, changes made without adequate reasons. Any such changes would hinder comparisons over time as to the amount of the mathematical reserves and so obscure trends in solvency and the emergence of surplus.

31/12/2004

PRU 7.3.12

The relevant factors referred to in PRU 7.3.10 R (4) may include, but are not limited to, factors such as future investment returns, expenses, mortality, morbidity, options, persistency and reinsurance (see also PRU 7.3.13 R to PRU 7.3.19 G).

31/12/2004

Margins for adverse deviation

PRU 7.3.13

The appropriate margins for adverse deviation required by PRU 7.3.10 R (4) must be sufficiently prudent to ensure that there is no significant foreseeable risk that liabilities to policyholders in respect of long-term insurance contracts will not be met as they fall due.

31/12/2004

PRU 7.3.14

The margins for adverse deviation are a prudential margin in respect of the risks that arise under a long-term insurance contract.

31/12/2004

PRU 7.3.15

PRU 7.3.13 R sets the normal standard of prudence required for margins. PRU 7.3.16 G suggests benchmarks against which a firm should compare the margins it has set in accordance with PRU 7.3.10 R (4) and PRU 7.3.13 R. PRU 7.3.17 G gives guidance where a market risk premium is not readily obtainable.

31/12/2004

PRU 7.3.16

When setting the margins for adverse deviation required by PRU 7.3.10 R (4) in relation to a particular contract, a firm should consider, where appropriate:

(1) the margin for adverse deviation included in the premium for similar long-term insurance contracts, if any, newly issued by the firm; and
(2) where a sufficiently developed and diversified market for transferring a risk exists, the risk premium that would be required by an unconnected party to assume the risk in respect of the contract.

The margin for adverse deviation of a risk should generally be greater than or equal to the relevant market price for that risk.

31/12/2004

PRU 7.3.17

Where a risk premium is not readily available, or cannot be determined, an external proxy for the risk should be used, such as adjusted industry mortality tables. Where there is a considerable range of possible outcomes, the FSA expects firms to use stochastic techniques to evaluate these risks. In time, for example, longevity risk, where this constitutes a significant risk for the firm, may fall into this category.

31/12/2004

PRU 7.3.18

The margins for adverse deviation should be recognised as profit only as the firm itself is released from risk over the duration of the contract.

31/12/2004

PRU 7.3.19

Further detailed rules and guidance on margins for adverse deviation are included in PRU 7.3.32 G to PRU 7.3.91 G . In particular, the cross-references for the different assumptions used in calculating the mathematical reserves are as follows:

(1) expenses (PRU 7.3.50 R to PRU 7.3.58 G);
(2) mortality and morbidity (PRU 7.3.59 R to PRU 7.3.61 G);
(3) options (PRU 7.3.62 R to PRU 7.3.72 G);
(4) persistency (PRU 7.3.73 G to PRU 7.3.77 G); and
(5) reinsurance ( PRU 7.3.78 G to PRU 7.3.91 G).

The rules and guidance on margins for adverse deviation in respect of future investment returns, which are also required in the calculation of mathematical reserves, are set out in PRU 4.2.28 R to PRU 4.2.48 G.

31/12/2004

Record keeping

PRU 7.3.20

A firm must make, and retain for an appropriate period, a record of:

(1) the methods and assumptions used in establishing its mathematical reserves, including the margins for adverse deviation, and the reasons for their use; and
(2) the nature of, reasons for, and effect of, any change in approach, including the amount by which the change in approach increases or decreases its mathematical reserves.

31/12/2004

PRU 7.3.21

PRU 1.4.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of PRU 7.3.20 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate period, a firm should have regard to:

(1) the detailed rules and guidance on record keeping in PRU 1.4.51 G - PRU 1.4.64 G;
(2) the nature and term of the firm's long-term insurance business; and
(3) any additional provisions or statutory requirements applicable to the firm or its records.

31/12/2004

Valuation of individual contracts

PRU 7.3.22

(1) Subject to (2) and (3), a firm must determine the amount of the mathematical reserves separately for each long-term insurance contract.
(2) Approximations or generalisations may be made where they are likely to provide the same, or a higher, result.
(3) A firm must set up additional mathematical reserves on an aggregated basis for general risks that are not specific to individual contracts.

31/12/2004

PRU 7.3.23

PRU 7.3.22 R to PRU 7.3.91 G set out rules and guidance for the separate prospective valuation of each contract. These may be applied instead to groups of contracts where the conditions set out in PRU 7.3.22 R (2) are satisfied.

31/12/2004

Contracts not to be treated as assets

PRU 7.3.24

A firm must not treat a long-term insurance contract as an asset.

31/12/2004

PRU 7.3.25

A separate prospective valuation for each contract may identify contracts for which the value of future cash inflows exceeds that of outflows, that is, the contracts have an asset value, rather than liability value. However, the surrender value of a contract is always greater than or equal to zero and the Consolidated Life Directive requires that no contract should be valued at less than its guaranteed surrender value. As a result, no contract should be treated as an asset.

31/12/2004

Avoidance of future valuation strain

PRU 7.3.26

(1) A firm must establish mathematical reserves for a contract of insurance which are sufficient to ensure that, at any subsequent date, the mathematical reserves then required are covered solely by:

(a) the assets covering the current mathematical reserves; and
(b) the resources arising from those assets and from the contract itself.

(2) For the purposes of (1), the firm must assume that:

(a) the assumptions adopted for the current valuation of liabilities remain unaltered and are met; and
(b) discretionary benefits and charges will be set so as to fulfil its regulatory duty to treat its customers fairly.

(3) (1) may be applied to a group of similar contracts instead of to the individual contracts within that group.

31/12/2004

PRU 7.3.27

The valuation of each contract, or group of similar contracts, should allow for the possibility, where it exists, that contracts may be surrendered (wholly or in part), lapsed or made paid-up at any time. The valuation assumptions include margins for adverse deviation (see PRU 7.3.13 R). PRU 7.3.26 R requires mathematical reserves to be established such that, if future experience is in line with the valuation assumptions, there would be no future valuation strain.

31/12/2004

Cash flows to be valued

PRU 7.3.28

In a prospective valuation, a firm must include the following in the cash flows to be valued:

(1) future premiums (see PRU 7.3.35 G to PRU 7.3.47 G);
(2) expenses, including commissions (see PRU 7.3.50 R to PRU 7.3.58 G);
(3) benefits payable (see PRU 7.3.29 R); and
(4) amounts to be received or paid in respect of the long-term insurance contracts under contracts of reinsurance or analogous non-reinsurance financing agreements (PRU 7.3.78 G to PRU 7.3.91 G).

31/12/2004

PRU 7.3.29

For the purpose of PRU 7.3.28 R (3), benefits payable include:

(1) all guaranteed benefits including guaranteed surrender values and paid-up values;
(2) vested, declared and allotted bonuses to which the policyholder is entitled;
(3) all options available to the policyholder under the terms of the contract; and
(4) discretionary benefits payable in accordance with the firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.3.30

All cash flows are to be valued using prudent assumptions in accordance with generally accepted actuarial practice. Cash flows may be omitted from the valuation calculations provided the reserves obtained as a result of leaving those cash flows out of the calculation are not less than would have resulted had all cash flows been included (see PRU 7.3.22 R (2)). Provision for future expenses in respect of with-profits insurance contracts (excluding accumulating with-profits policies) may be made implicitly, using the net premium method of valuation (see PRU 7.3.43 R below). For the purposes of PRU 7.3.28 R (2), any charges included in expenses should be determined in accordance with the firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.3.31

PRU 7.3.29 R (4) requires regulatory basis only life firms to make allowance for any future annual bonus that a firm would expect to grant, assuming future experience is in line with the assumptions used in the calculation of the mathematical reserves. Final bonuses do not have to be taken into consideration in these calculations (see PRU 7.3.9 R). For realistic basis life firms, except for accumulating with-profits policies, the mathematical reserves may be calculated as the amount required to cover guaranteed benefits as for such firms full allowance for discretionary benefits is made in the calculation of the realistic value of liabilities (see PRU 7.4.105 R (5)). The calculations required for accumulating with-profits policies are set out in PRU 7.3.71 R (1).

31/12/2004

Valuation assumptions: detailed rules and guidance

PRU 7.3.32

More detailed rules and guidance about the valuation of cash flows are set out in PRU 7.3.33 R to PRU 7.3.91 G .

31/12/2004

Valuation rates of interest

PRU 7.3.33

In calculating the present value of future net cash flows, a firm must determine the rates of interest to be used in accordance with PRU 4.2.28 R to PRU 4.2.47 R.

31/12/2004

PRU 7.3.34

The rules in PRU 4.2.28 R to PRU 4.2.47 R set out the approach firms must take in setting margins for adverse deviation in the interest rates assumed in calculating the mathematical reserves. This includes a margin to allow for adverse deviation in market risk and, where relevant, credit risk. The requirements set out in PRU 4.2.28 R to PRU 4.2.47 R protect against the market risk that the return actually achieved on assets may fall below the market yields on assets at the actuarial valuation date.

31/12/2004

Future premiums

PRU 7.3.35

PRU 7.3.46 R and PRU 7.3.47 G apply to the valuation of with-profits insurance liabilities for a realistic basis life firm. PRU 7.3.38 R to PRU 7.3.45 G apply to a regulatory basis only life firm.

31/12/2004

PRU 7.3.36

For non-profit insurance contracts no specific method of valuation for future premiums is required by PRU. However, the method of valuation used should be sufficiently prudent taking into account, in particular, the risk of voluntary discontinuance by the policyholder.

31/12/2004

Future premiums: firms reporting only on a regulatory basis

PRU 7.3.37

PRU 7.3.38 R to PRU 7.3.43 R apply to a regulatory basis only life firm.

31/12/2004

PRU 7.3.38

(1) This rule applies to with-profits insurance contracts except accumulating with-profits policies written on a recurring single premium basis.
(2) The value attributed to a premium due in any future financial year (a future premium) must not exceed the lower of the value of:

(a) the actual premium payable under the contract; and
(b) the net premium.

(3) The net premium may be increased for deferred acquisition costs in accordance with PRU 7.3.43 R.

31/12/2004

PRU 7.3.39

The valuation method for future premiums in PRU 7.3.38 R retains the difference, if any, between the gross premium and the net premium as an implicit margin available to finance future bonuses, expenses and other costs. It thus helps to protect against the risk that adequate resources may not be available in the future to meet those costs.

31/12/2004

PRU 7.3.40

Where the terms of a contract of insurance have changed since it was first entered into, a firm must apply one of the methods in PRU 7.3.41 R in determining the net premium for the purpose of PRU 7.3.38 R (2)(b).

31/12/2004

PRU 7.3.41

A firm must treat the change referred to in PRU 7.3.40 R as if either:

(1) it had been included in the original contract but came into effect from the time the change became effective; or
(2) the original contract were cancelled and replaced by a new contract (with an initial premium paid on the new contract equal to the liability under the original contract immediately prior to the change); or
(3) it gave rise to two separate contracts where:

(a) all premiums are payable under the first contract and that contract provides only for such benefits as those premiums could have purchased from the firm at the date the change became effective; and
(b) no premiums are payable under the second contract and that contract provides for all the other benefits.

31/12/2004

PRU 7.3.42

PRU 7.3.41 R permits three alternative methods. However, the third method is only possible where a meaningful comparison can be made between the terms of the contract (as changed) and the terms upon which the firm was effecting its new contracts of insurance at the time the contract was changed.

31/12/2004

Future net premiums: adjustment for deferred acquisition costs

PRU 7.3.43

(1) The amount of any increase to the net premium for deferred acquisition costs must not exceed the equivalent of the recoverable acquisition expenses spread over the period of premium payments and calculated in accordance with the rates of interest, mortality and morbidity assumed in calculating the mathematical reserves.
(2) For the purpose of (1), recoverable acquisition expenses means the amount of expenses, after allowing for the effects of taxation, which it is reasonable to expect will be recovered from future premiums payable under the contract.
(3) The recoverable acquisition expenses in (1) must not exceed the lower of:

(a) the value of the excess of actual premiums over net premiums; and
(b) 3.5% of the relevant capital sum.

(4) Recoverable acquisition expenses may be calculated as the average for a group of similar contracts weighted by the relevant capital sum for each contract.

31/12/2004

PRU 7.3.44

PRU 7.3.43 R allows a firm to spread acquisition costs over the lifetime of a contract of insurance, but only if it is reasonable to expect those costs to be recoverable from future premium income from that contract. Further prudence is provided by the limitation of recoverable acquisition expenses to 3.5% of the relevant capital sum. This adjustment for acquisition costs is sometimes termed a Zillmer adjustment.

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PRU 7.3.45

In determining the extent, if any, to which it is reasonable to expect acquisition costs to be recoverable from future premium income, the firm should make prudent assumptions as to levels of voluntary discontinuance by policyholders.

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Future premiums: firms also reporting with-profits insurance liabilities on a realistic basis

PRU 7.3.46

(1) Subject to (2), for a realistic basis life firm, the future premiums to be valued in the calculation of the mathematical reserves for its with-profits insurance contracts must not be greater than the gross premiums payable by the policyholder.
(2) This rule does not apply to accumulating with-profits policies written on a recurring single premium basis (see PRU 7.3.48 R).

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PRU 7.3.47

The gross premium is the full amount of premium payable by the policyholder to the firm. The gross premium method contrasts with the net premium method which is required from regulatory basis only life firms (see PRU 7.3.37 R to PRU 7.3.45 G).

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Future premiums: accumulating with-profits policies

PRU 7.3.48

(1) This rule applies to accumulating with-profits policies written on a recurring single premium basis.
(2) A firm must not attribute any value to a future premium under the contract.
(3) Any liability arising only upon the payment of that premium may be ignored except to the extent that the value of that liability upon payment would exceed the amount of that premium.

31/12/2004

PRU 7.3.49

PRU 7.3.48 R prohibits a firm from taking credit for recurring single premiums under accumulating with-profits policies. As there is no contractual commitment to pay any future premiums the amount and timing of which are uncertain, the recognition of any potential margins would not be prudent. Where the payment of a future premium would give rise to a liability in excess of the premium a provision should be established.

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Expenses

PRU 7.3.50

(1) A firm must make provision for expenses, either implicitly or explicitly, in its mathematical reserves of an amount which is not less than the amount expected, on prudent assumptions, to be incurred in fulfilling its long-term insurance contracts.
(2) For the purpose of (1), expenses must be valued:

(a) after taking account of the effect of taxation;
(b) having regard to the firm's actual expenses in the last 12 months before the actuarial valuation date and any increases in expenses expected to occur in the future;
(c) after making prudent assumptions as to the effects of inflation on future increases in prices and earnings; and
(d) at no less than the level that would be incurred if the firm were to cease to transact new business 12 months after the actuarial valuation date.

(3) A firm must not rely upon an implicit provision arising from the method of valuing future premiums except to the extent that:

(a) it is reasonable to assume that expenses will be recoverable from future premiums; and
(b) the expenses would only arise if the future premiums were received.

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PRU 7.3.51

For with-profits insurance contracts where the net premium valuation method applies, an implicit provision arises because the future premiums valued are limited to the net premium adjusted as permitted by PRU 7.3.43 R. This excludes the allowance within the gross premium for expenses (other than recoverable acquisition expenses). It also excludes other margins within the actual premium that are a prudential margin in respect of the risks that arise under the contract or that are needed to provide for future discretionary benefits. To the extent that these other margins are not needed for the purpose for which they were originally established, they may also constitute an implicit provision for expenses.

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PRU 7.3.52

An implicit provision may also arise for other types of long-term insurance contract where, for example, no value is attributed to future premiums, but the firm is entitled to make deductions from future regular premiums before allocating them to secure policyholder benefits.

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PRU 7.3.53

A firm should only reduce the provision for future expenses to take account of expected taxation recoveries related to those expenses where recovery is reasonably certain, and after taking into account the assumption that the firm ceases to transact new business 12 months after the actuarial valuation date. An appropriate adjustment for discounting should be made where receipt of the taxation recoveries is not expected until significantly after the expenses are incurred.

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PRU 7.3.54

The firm's actual expenses in the 12 months prior to the actuarial valuation date may serve as a guide to the assumptions for future expenses, taking into consideration the mix of acquisition and renewal expenses. The expense assumptions should not be reduced to account for expected future improvements in efficiency until such efficiency improvements result in a reduced level of actual expenditure. However, the assumptions should take account of all factors which might increase costs including earnings and price inflation.

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PRU 7.3.55

The provisions for expenses (whether implicit or explicit) required by PRU 7.3.50 R must be sufficient to cover all the expenses of running off the firm's existing long-term insurance business including:

(1) all discontinuance costs (for example, redundancy costs and closure costs) that would arise if the firm were to cease transacting new business 12 months after the actuarial valuation date in circumstances where (and to the extent that) the discontinuance costs exceed the projected surplus available to meet such costs;
(2) all costs of continuing to service the existing business taking into account the loss of economies of scale from, and any other likely consequences of, ceasing to transact new business at that time; and
(3) the lower of:

(a) any projected valuation strain from writing new business for the 12 months following the actuarial valuation date to the extent the actual amount of that strain exceeds the projected surplus on prudent assumptions from existing business in the 12 months following the actuarial valuation date; and
(b) any projected new business expense overrun from writing new business for the 12 months following the actuarial valuation date to the extent the projected expenses exceed the expenses that the new business can support on a prudent basis.

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PRU 7.3.56

The provision for future expenses, whether implicit or explicit, should include a prudent margin for adverse deviation in the level and timing of expenses (see PRU 7.3.13 R to PRU 7.3.19 G). The margin should cover the risk of underestimating expenses whether due to, for example, initial under-calculation or subsequent increases in the amount of expenses. In setting the amount of the margin, the firm should take into account the extent to which:

(1) an appropriately validated method based on reliable data is used to allocate expenses by product type, by distribution channel and as between acquisition and non-acquisition expenses;
(2) the volume of existing and new business and its distribution by product type or distribution channel is stable or predictable;
(3) costs vary in the short, medium or long term dependent upon the volume of existing or new business and its distribution by product type or distribution channel; and
(4) cost control is well-managed.

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PRU 7.3.57

In setting the margin, the firm should also take into account:

(1) the length of the period over which it is necessary to project costs;
(2) the extent to which it is reasonable to expect inflation to be stable or predictable over that period; and
(3) whether, if inflation is higher than expected, it is reasonable to expect that the excess would be offset by increases in investment returns.

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PRU 7.3.58

Where a firm has entered into an agreement with any other person for the sharing or reimbursement of costs, in setting the margin it should take into account the potential impact of that agreement and of its discontinuance.

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Mortality and Morbidity

PRU 7.3.59

A firm must set the assumptions for mortality and morbidity using prudent rates of mortality and morbidity that are appropriate to the country or territory of residence of the person whose life or health is insured.

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PRU 7.3.60

The rates of mortality or morbidity should contain prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G). In setting those rates, a firm should take account of:

(1) the systems and controls applied in underwriting long-term insurance contracts and whether they provide adequate protection against anti-selection (that is, selection against the firm) including:

(a) adequately defining and identifying non-standard risks; and
(b) where such risks are underwritten, allocating to them an appropriate weighting;

(2) the nature of the contractual exposure to mortality or morbidity risk including:

(a) whether lower mortality increases or decreases the firm's liability;
(b) the period of cover and whether risk charges can be varied during that period and, if so, how quickly; and
(c) whether the options in the contract give rise to a significant risk of anti-selection (for example, opportunities for voluntary discontinuance, guaranteed renewal at the option of the policyholder and rights for conversion of benefits);

(3) the credibility of the firm's actual experience as a basis for projecting future experience including:

(a) whether there is sufficient data (especially for medical or financial risks and for new types of benefit or new methods of distribution); and
(b) whether the data is reliable and has been appropriately validated;

(4) the availability and reliability of:

(a) any published tables of mortality or morbidity for the country or territory of residence of the person whose life or health is insured; and
(b) any other information as to the industry-wide insurance experience for that country or territory;

(5) anticipated or possible future trends in experience including, but only where they increase the liability:

(a) anticipated improvements in mortality;
(b) changes arising from improved detection of morbidity (including critical illnesses);
(c) diseases the impact of which may not yet be reflected fully in current experience; and
(d) changes in market segmentation (such as impaired life annuities) which, in the light of developing experience, may require different assumptions for different parts of the policy class.

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PRU 7.3.61

An additional provision for diseases covered by PRU 7.3.60 G (5)(c) may be needed, in particular for unit-linked policies. In determining whether such a provision is needed a firm may take into consideration any ability to increase product charges commensurately (provided that such increase does not infringe on its regulatory duty to treat its customers fairly), but a provision would still be required for the period until such an increase could be brought into effect.

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Options

PRU 7.3.62

When a firm establishes its mathematical reserves in respect of a long-term insurance contract, the firm must include an amount to cover any increase in liabilities which might be the direct result of its policyholder exercising an option under, or by virtue of, that contract of insurance. Where the surrender value of a contract is guaranteed, the amount of the mathematical reserves for that contract at any time must be at least as great as the value guaranteed at that time.

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PRU 7.3.63

An option exists where a policyholder is given a choice between alternative forms of benefit, for example, a choice between receiving a cash benefit upon maturity or an annuity at a guaranteed rate. In some cases, the contract may designate one or other of these alternatives as the principal benefit and any other as an option. This designation, in itself, is not one of substance in the context of reserving since it does not affect the policyholder's choices. Other forms of option include:

(1) the right to convert to a different contract on guaranteed terms;
(2) the right to increase cover on guaranteed terms;
(3) the right to a specified amount on surrender; and
(4) the right to a paid up value.

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PRU 7.3.64

The firm should provide for the benefit which the firm anticipates the policyholder is most likely to choose. Except for the "option" of voluntary discontinuance in the case of regulatory basis only life firms (see PRU 7.3.74 R), past experience may be used as a guide, but only if this is likely to give a reasonable estimate of future experience. For example, past experience of the take-up of a cash payment option instead of an annuity would not be a reliable guide, if, in the past, market rates exceeded those guaranteed in the annuity but no longer do so. Similarly, past experience on the take-up of options may not be relevant in the light of the assumptions made in respect of future interest rates and mortality rates in the valuation of the benefits.

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PRU 7.3.65

Many options are long-term and need careful consideration. Improving longevity, for example, can increase the value of guaranteed annuity options vesting further in the future. Firms also need to have regard to the fact that policyholder behaviour can change in the future as policyholders become more aware of the value of their options. The impact on policyholder behaviour of possible changes in taxation should also be considered.

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PRU 7.3.66

In accordance with PRU 7.3.7 R and PRU 7.3.13 R, take-up rates for guaranteed annuity options should be assessed on a prudent basis with assumptions that include margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) that take account of current experience and the potential for future change. The firm should reserve for option take-up at least at a prudent margin over current experience for options shortly to vest. For longer term options where the option becomes increasingly valuable in the future due to projected mortality improvements, increased take-up rates should be assumed. In view of the growing uncertainty over take-up rates for projections further in the future, for guaranteed annuity option dates 20 years or more ahead at least a 95% take-up rate assumption should be made.

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PRU 7.3.67

Where there is considerable variation in the cost of the option depending on conditions at the time the option is exercised, and where that variation constitutes a material risk for the firm, it will generally be appropriate to use stochastic modelling. In this case prices from the asset model used in the stochastic approach should be benchmarked to relevant market asset prices before determining the value of the option. Where stochastic modelling is not undertaken, market option prices should be used to determine suitable assumptions for the valuation of the option. If no market exists for a particular option, a firm should take the value of the nearest equivalent benefit or right for which a market exists and document the way in which it has adjusted that valuation to reflect the original option.

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PRU 7.3.68

Where the option offers a choice between two non-discretionary financial benefits (such as between a guaranteed cash sum or a guaranteed annuity value, or between a unit value and a maturity guarantee) and where there is a wide range of possible outcomes, the firm should normally model such liabilities stochastically. In carrying out such modelling firms should take into account the likely choices to be made by policyholders in each scenario. Firms should make and retain a record of the development and application of the model.

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PRU 7.3.69

The value of a contract with an option is greater than the value of a similar contract without the option, that is, the option has value whether it is expected to be exercised or not. Although in theory a firm can rebalance its investments to match the expected cost of the option to the firm (including the time value of the option), this takes time to achieve and the market may move more quickly than the firm is able to respond. Also, there are likely to be transaction costs. Firms should take these aspects into consideration in setting up mathematical reserves.

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PRU 7.3.70

(1) Where a policyholder may opt to be paid a cash amount, or a series of cash payments, the mathematical reserves for the contract of insurance established under PRU 7.3.7 R must be sufficient to ensure that the payment or payments could be made solely from:

(a) the assets covering those mathematical reserves; and
(b) the resources arising from those assets and from the contract itself.

(2) In (1) references to a cash amount or a series of cash payments include the amount or amounts likely to be paid on a voluntary discontinuance.
(3) For the purposes of (1), the firm must assume that:

(a) the assumptions adopted for the current valuation remain unaltered and are met; and
(b) discretionary benefits and charges will be set so as to fulfil the firm's regulatory duty to treat its customers fairly.

(4) (1) may be applied to a group of similar contracts instead of to the individual contracts within that group.

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PRU 7.3.71

For the purposes of PRU 7.3.70 R, a firm must assume that the amount of a cash payment secured by the exercise of an option is:

(1) in the case of an accumulating with-profits policy, the lower of:

(a) the amount which the policyholder would reasonably expect to be paid if the option were exercised, having regard to the representations made by the firm and including any expectations of a final bonus; and
(b) that amount, disregarding all discretionary adjustments;

(2) in the case of any other policy, the amount which the policyholder would reasonably expect to be paid if the option were exercised, having regard to the representations made by the firm, without taking into account any expectations regarding future distributions of profits or the granting of discretionary additions in respect of an established surplus.

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PRU 7.3.72

In PRU 7.3.71 R (1)(a) firms must take into consideration, for example, a market value adjustment where such an adjustment has been described in representations made to policyholders by the firm. However, any discretionary adjustment, such as a market value adjustment, cannot be included in the amount calculated in PRU 7.3.71 R (1)(b).

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Persistency assumptions

PRU 7.3.73

PRU 7.3.76 R and PRU 7.3.77 G apply to the valuation of the with-profits insurance liabilities of realistic basis life firms. PRU 7.3.74 R and PRU 7.3.75 G apply to the valuation of all other liabilities.

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PRU 7.3.74

Except as permitted by PRU 7.3.76 R, a firm must not make any allowance in the calculation of the mathematical reserves for the voluntary discontinuance of any contract of insurance if the amount of the mathematical reserves so determined would, as a result, be reduced.

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PRU 7.3.75

The rate of voluntary discontinuance (that is, lapse, surrender or paying up) is often difficult to predict and may be volatile especially in the short term during stressful economic conditions. Depending upon the circumstances and contract terms, voluntary discontinuance may increase or decrease the firm's liability. In effect, PRU 7.3.74 R requires a firm to assume that there will be no voluntary discontinuance if assuming voluntary discontinuance would reduce the liability. This protects against the risk that arises from volatility in the rate of voluntary discontinuance. In addition, there is the risk of assets not being realisable when needed due to the rates of discontinuance exceeding expected levels.

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PRU 7.3.76

A realistic basis life firm may make assumptions about voluntary discontinuance rates in the calculation of the mathematical reserves for its with-profits insurance business provided that those assumptions meet the general requirements for prudent assumptions as set out in PRU 7.3.10 R and PRU 7.3.13 R.

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PRU 7.3.77

The prudential margin in respect of assumptions of voluntary discontinuance should be validated both in relation to recent experience and to variations in future experience that might arise as a result of reasonably foreseeable changes in conditions. In particular, where estimates of experience are being made well into the future, the assumptions should contain margins that take into account the increased risk of adverse experience arising from changed circumstances. Firms should also consider the possibility of anti-selection by policyholders and of variations in persistency experience for different classes and cohorts of business.

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PRU 7.3.78

The prospective valuation of future cash flows to determine the amount of the mathematical reserves includes amounts to be received or paid under contracts of reinsurance in respect of long-term insurance business (see PRU 7.3.28 R (4)). This applies even where those cash flows cannot be identified as related to particular long-term insurance contracts (see PRU 7.3.22 R (3)).

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PRU 7.3.79

A firm must value reinsurance cash flows using methods and assumptions which are at least as prudent as the methods and assumptions used to value the underlying contracts of insurance which have been reinsured. In particular:

(1) reinsurance recoveries must not be recognised unless the underlying liabilities to which they relate have also been recognised;
(2) reinsurance cash outflows that are unambiguously linked to the emergence as surplus of margins included in the valuation of existing contracts of insurance or to the exercise by a reinsurer of its rights under a termination clause need not be valued (see PRU 7.3.85 R); and
(3) reinsurance cash inflows that are contingent on factors or conditions other than the insurance risks that are reinsured must not be valued.

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PRU 7.3.80

In valuing reinsurance cash flows, a firm should establish prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) including margins in respect of:

(1) any uncertainty as to the amount or timing of amounts to be paid or received; and
(2) the risk of credit default by the reinsurer.

31/12/2004

PRU 7.3.81

In assessing the risk of credit default, the firm should take into account the rules and guidance in PRU 3.2 (Credit risk in insurance).

31/12/2004

PRU 7.3.82

It will not necessarily be appropriate to use the same assumptions in PRU 7.3.79 R as for the underlying contracts. For example, if only a subgroup of the original contracts is reinsured, it may be appropriate to use different mortality rates.

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PRU 7.3.83

Only reinsurance cash inflows that are triggered unambiguously by the insurance risks of the firm that are reinsured may be valued. Reinsurance cash inflows that depend on other contingencies where the outcome does not form part of the valuation basis should not be given credit.

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PRU 7.3.84

Firms should assess the extent of margins in the valuation of the existing contracts of insurance where these provide implicit provision for the reinsurance cash outflows in PRU 7.3.79 R. Where the reinsurance asset exceeds the estimated value of the future surplus under reinsured contracts firms should assess their credit risk exposure to the reinsurer.

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PRU 7.3.85

For the purposes of PRU 7.3.79 R (2), the "link" must be such that a contingent liability to pay or repay the amount to the reinsurer could not arise except when, and to the extent that, the margins in the valuation of the existing contracts of insurance emerge as surplus, or the reinsurer exercises its rights under a termination clause as a result of fraud, misrepresentation, the non-payment of reinsurance premiums by the firm or a failure by the firm to obtain the agreement of the reinsurer to a transfer of business by the firm.

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PRU 7.3.86

For the purposes of PRU 7.3.79 R (2) and PRU 7.3.85 R, future surplus may only be offset against future reinsurance cash outflow in respect of surplus on non-profit insurance contracts and the charges or shareholder transfers arising as surplus from with-profits insurance contracts. Such charges and transfers may only be allowed for to the extent consistent with the regulatory duty of the firm to treat its customers fairly.

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PRU 7.3.87

For the purposes of PRU 7.3.85 R, a contingent liability means a liability that would only arise upon the happening of a particular contingency, even where that contingency is not expected to occur. For example, if the firm has a reinsurance arrangement in force that in the event the firm were wound up would give rise to repayments other than out of surplus emerging, the reinsurance cash outflows should be valued as a liability.

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PRU 7.3.88

PRU 7.3.85 R allows a firm not to value reinsurance cash outflows provided the contingencies in which the reinsurance would require repayment other than out of future surpluses are limited to termination clauses concerning fraud, misrepresentation, non-payment of reinsurance premiums by the firm or a failure by the firm to obtain the agreement of the reinsurer to a transfer of business by the firm.

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PRU 7.3.89

Where the reinsurance cash outflow is payable by a fund or sub-fund that generates such profits, charges or transfers, the firm need make no provision for such payments provided that repayment to the reinsurer is linked unambiguously (as defined in PRU 7.3.85 R) to the emergence of future surplus. Where the profits, charges or transfers arising under a block of business are payable by a fund or sub-fund to another part of the firm then only where the firm has committed to remit such profits, charges or transfers directly to the reinsurer would it be acceptable for no provision for payments to the reinsurer to be made.

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PRU 7.3.90

In PRU 7.3.78 G to PRU 7.3.89 G references to reinsurance and contracts of reinsurance include analogous non-reinsurance financing agreements.

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PRU 7.3.91

In PRU 7.3.78 G to PRU 7.3.89 G references to reinsurance cash outflow include any provision for the reduction in policy liabilities recognised as covered under a contract of reinsurance or for the reduction of any debt to the firm previously created under a contract of reinsurance. In PRU 7.3.90 R analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

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PRU 7.4

With-profits insurance capital component

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Application

PRU 7.4.1

PRU 7.4 applies to a realistic basis life firm.

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PRU 7.4.2

A realistic basis life firm means a firm to which PRU 2.1.15 R applies. The application of PRU 2.1.15 R is set out in PRU 2.1.16 R and PRU 2.1.17 R. PRU 2.1.9 R requires that a firm must maintain at all times capital resources equal to or in excess of its capital resources requirement. The enhanced capital requirement forms part of the capital resources requirement for a realistic basis life firm. The with-profits insurance capital component forms part of the enhanced capital requirement which a realistic basis life firm is required to calculate in accordance with PRU 2.1.34 R.

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Purpose

PRU 7.4.3

This section sets out rules and guidance as to the methods and assumptions to be used in calculating the with-profits insurance capital component.

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PRU 7.4.4

The purpose of the with-profits insurance capital component is to supplement the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In particular, capital in excess of the mathematical reserves may be needed to ensure that adequate final bonuses can be awarded to policyholders. That is, adequate in the sense that in setting bonuses payable to policyholders the firm pays due regard to the interests of its policyholders and treats them fairly. The mathematical reserves for a realistic basis life firm are not required to include provision for future annual bonuses or final bonuses (PRU 7.3.9 R).

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PRU 7.4.5

The required procedures are summarised in the flowchart in PRU 7 Annex 1G.

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Main requirements

PRU 7.4.6

A firm must calculate the with-profits insurance capital component in accordance with PRU 7.4.7 R.

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PRU 7.4.7

(1) The with-profits insurance capital component for a firm is the aggregate of any amounts that:

(a) result from the calculations specified in (2) and (3); and
(b) are greater than zero.

(2) Subject to (3), in relation to each with-profits fund within the firm, the firm must deduct B from A, where:

(a) A is the amount of the regulatory excess capital for that fund (see PRU 7.4.23 R); and
(b) B is the amount of the realistic excess capital for that fund (see PRU 7.4.32 R).

(3) Where a capital instrument that can be included in the firm's capital resources in accordance with PRU 2.2 has been attributed wholly or partly to a with-profits fund and that instrument meets the requirements of PRU 2.2.93 R, the firm must add to the amount calculated under (2) for that fund the result, subject to a minimum of zero, of deducting D from C where:

(a) C is the outstanding face amount of the instrument to the extent attributed to the fund; and
(b) D is the realistic value of the instrument to the extent attributed to the fund in the single event that determines the risk capital margin under PRU 7.4.43 R.

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PRU 7.4.8

Subordinated debt which is subordinated to policyholder interests (see PRU 2.2.93 R is an example of the sort of capital instrument that may give rise to a component of the WPICC under PRU 7.4.7 R (3). Such instruments are treated as capital under PRU 2.2, subject to the requirements of PRU 2.2.93 R. Under realistic reserving the capital instrument is valued as a realistic liability (PRU 7.4.40 R) and in calculating the risk capital margin such an instrument would be valued at its realistic value in the single event outlined in PRU 7.4.43 R (see also PRU 7.4.162 R). Overall, the effect of PRU 2.2, PRU 7.4.7 R (3) and PRU 7.4.43 R is to enable a firm that obtains subordinated debt to benefit from additional capital resources equal to the face amount of that debt.

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PRU 7.4.9

SUP 4 (Actuaries) sets out the role and responsibilities of the actuarial function and of the with-profits actuary.

(1) As part of his duties under SUP 4.3.13 R, the actuary appointed by the firm to perform the actuarial function must calculate the firm's mathematical reserves and, in the context of the calculation of the with-profits insurance capital component, must also:

(a) advise the firm's governing body on the methods and assumptions to be used in the calculation of the firm's with-profits insurance capital component;
(b) perform that calculation in accordance with the methods and assumptions determined by the firm's governing body; and
(c) report to the firm's governing body on the results of that calculation.

(2) As part of his duties under SUP 4.3.16 G, the with-profits actuary must advise the firm's governing body on the discretion exercised by the firm. In the context of the calculation of the with-profits insurance capital component, the with-profits actuary must also advise the firm's governing body as to whether the methods and assumptions (including the allowance for management actions) used for that calculation are consistent with the firm's Principles and Practices of Financial Management (PPFM - see COB 6.10 ) and with its regulatory duty to treat its customers fairly.

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Definitions

PRU 7.4.10

In this section, real estate means an interest in land, buildings or other immovable property.

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PRU 7.4.11

In this section, the long-term gilt yield is the annualised equivalent of the yield on the 15-year index for United Kingdom Government fixed-interest securities jointly compiled by the Financial Times, the Institute of Actuaries and the Faculty of Actuaries.

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PRU 7.4.12

For the purposes of this section, a firm has an exposure to an asset or liability where the firm's valuation of its assets or liabilities changes when the value of the asset or liability changes.

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PRU 7.4.13

Unless the context otherwise requires, all references (however expressed) in this section to realistic liabilities, or to liabilities which are included in the calculation of realistic liabilities, include discretionary benefits payable by the firm in accordance with the firm's regulatory duty to treat its customers fairly.

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PRU 7.4.14

In this section, any reference to a firm's regulatory duty to treat its customers fairly is a reference to the firm's duty under Principle 6 (Customers' interests). This states that a firm must pay due regard to the interests of its customers and treat them fairly.

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PRU 7.4.15

In this section, any reference to the Principles and Practices of Financial Management (PPFM) is a reference to the requirements in COB 6.10 (Principles and Practices of Financial Management) for firms to establish, maintain and record the principles and practices of financial management according to which the business of its with-profits funds is conducted.

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PRU 7.4.16

The extent to which a firm requires a separate PPFM for each of its with-profits funds will depend on the firm's circumstances and any relevant representations made by the firm to its with-profits policyholders. In this section, any reference to a firm's PPFM refers to the PPFM which relate to the with-profits fund or the with-profits insurance contracts in question.

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Record keeping

PRU 7.4.17

A firm must make, and retain for an appropriate period of time, a record of:

(1) the methods and assumptions used in making any calculation required for the purposes of this section (and any subsequent changes) and the reasons for their use; and
(2) any change in practice and the nature of, reasons for, and effect of, any change in approach with respect to those methods and assumptions.

31/12/2004

PRU 7.4.18

PRU 1.4.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of PRU 7.4.17 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate time period, a firm should have regard to:

(1) the detailed guidance on record keeping in PRU 1.4.51 G to PRU 1.4.64 G;
(2) the nature and term of the firm's long-term insurance contracts; and
(3) any additional provisions or statutory requirements applicable to the firm or its records.

31/12/2004

PRU 7.4.19

A firm must also identify in the record required to be kept by PRU 7.4.17 R changes in practice, in particular changes in those items which will or may be significant in relation to the eventual claim values.

31/12/2004

PRU 7.4.20

Some of the changes identified in accordance with PRU 7.4.19 R may have to be notified to the firm's policyholders in accordance with the firm's PPFM.

31/12/2004

General principles for allocating aggregate amounts

PRU 7.4.21

Where any calculation is required under this section which:

(1) is to be made in respect of any with-profits fund of a firm; and
(2) covers an amount that is otherwise calculated in relation to the firm as a whole;

the firm must make an allocation of that amount as between all of its funds (including funds which are not with-profits funds).

31/12/2004

PRU 7.4.22

In any case where:

(1) non-profit insurance contracts are written in any with-profits fund of a firm; and
(2) any calculation is required under this section which:

(a) is to be made in respect of the regulatory excess capital or realistic excess capital for the fund; and
(b) covers an amount that is otherwise calculated or allocated in relation to the fund as a whole;

the firm must make an allocation of the amount in (2)(b) as between the with-profits insurance contracts and non-profit insurance contracts written in the fund.

31/12/2004

Calculation of regulatory excess capital

PRU 7.4.23

A firm must calculate the regulatory excess capital for each of its with-profits funds by deducting B from A, where:

(1) A is the regulatory value of assets of the fund (PRU 7.4.24 R); and
(2) B is the sum of:

(a) the regulatory value of liabilities of the fund (PRU 7.4.29 R);
(b) the long-term insurance capital requirement in respect of the fund's with-profits insurance contracts; and
(c) the resilience capital requirement in respect of the fund's with-profits insurance contracts.

31/12/2004

Regulatory value of assets

PRU 7.4.24

(1) For the purposes of PRU 7.4.23 R (1), the regulatory value of assets of a with-profits fund is equal to the sum of:

(a) the amount of the fund's long-term admissible assets; and
(b) the amount of any implicit items allocated to that fund;

less an amount, representing any non-profit insurance contracts written in that fund, determined in accordance with (2).
(2) Where non-profit insurance contracts are written in a with-profits fund, the amount representing those contracts is the sum of:

(a) the mathematical reserves in respect of the non-profit insurance contract written in the fund; and
(b) the following amounts, to the extent that each of them is covered by the fund's long-term admissible assets:

(i) an amount in respect of the non-profit insurance contracts written in the fund which represents an appropriate allocation of the firm's long-term insurance capital requirement; and
(ii) an amount in respect of the non-profit insurance contracts written in the fund which represents an appropriate allocation of the firm's resilience capital requirement.

31/12/2004

PRU 7.4.25

For the purpose of determining the value of a fund's long-term admissible assets in accordance with PRU 7.4.24 R (1)(a), no value is to be attributed to debts and claims other than in respect of:

(1) amounts that have already fallen due; and
(2) tax recoveries and claims against compensation funds to the extent not already offset in the mathematical reserves.

31/12/2004

PRU 7.4.26

In making a determination in accordance with PRU 7.4.24 R (2), a firm must allocate long-term admissible assets of an appropriate nature and term to any non-profit insurance contracts written in the with-profits fund.

31/12/2004

PRU 7.4.27

In calculating the amount of a firm's resilience capital requirement allocated to the non-profit insurance contracts in the with-profits fund, the firm should calculate the amount of resilience capital that would be required if that business were in a stand-alone company owning the assets allocated. The resilience capital requirement for the with-profits insurance business should also be calculated as if it were a stand-alone company. An allocation of the firm's total resilience capital requirement should then be made in a manner that would produce a result materially consistent with an allocation in proportion to the amounts calculated for each part of the business as stand-alone entities.

31/12/2004

PRU 7.4.28

A firm needs to obtain an implicit item waiver from the FSA in order to bring in an amount under PRU 7.4.24 R (1)(b). For guidance on applying for an implicit item waiver in respect of future surpluses relating to with-profits funds see PRU 2 Annex 2. The amount of any implicit item allocated to a with-profits fund may be defined in the terms of any waiver granted.

31/12/2004

Regulatory value of liabilities

PRU 7.4.29

For the purposes of PRU 7.4.23 R (2)(a), the regulatory value of liabilities of a with-profits fund is equal to the sum of:

(1) the mathematical reserves, in respect of the fund's with-profits insurance contracts, including the value of any provisions reflecting bonuses allocated at the actuarial valuation date; and
(2) the regulatory current liabilities of the fund (see PRU 7.4.30 R).

31/12/2004

PRU 7.4.30

For the purposes of PRU 7.4.29 R (2), the regulatory current liabilities of a with-profits fund are equal to the sum of the following amounts to the extent that they relate to that fund:

(1) accounting liabilities (including long-term insurance liabilities which have fallen due before the end of the financial year);
(2) liabilities from deposit back arrangements; and
(3) any provision for adverse variations (determined in accordance with PRU 4.3.17 R).

31/12/2004

PRU 7.4.31

The amount of regulatory current liabilities for a with-profits fund refers to the sum of the amounts in (1) and (2) in respect of the fund:

(1) the amount of 'Total other insurance and non-insurance liabilities'; and
(2) the amount of 'Cash bonuses which had not been paid to policyholders prior to the end of the financial year';

as disclosed at lines 49 and 12 respectively of the appropriate Form 14 ('Long-term business liabilities and margins') for that fund as part of the Annual Returns required to be deposited with the FSA under IPRU(INS) rule 9.6(1).

31/12/2004

Calculation of realistic excess capital

PRU 7.4.32

A firm must calculate the realistic excess capital for each of its with-profits funds by deducting B from A, where:

(1) A is the realistic value of assets of the fund (see PRU 7.4.33R); and
(2) B is the sum of:

(a) the realistic value of liabilities of the fund (see PRU 7.4.40 R); and
(b) the risk capital margin for the fund (see PRU 7.4.43 R).

31/12/2004

Realistic value of assets

PRU 7.4.33

(1) For the purposes of PRU 7.4.32 R (1), the realistic value of assets of a with-profits fund is the sum of:

(a) the amount of the fund's regulatory value of assets determined in accordance with PRU 7.4.24 R, but with no value given to any implicit items and excluding the regulatory value of any shares in a related undertaking which carries on long-term insurance business;
(b) the amount of the fund's excess admissible assets (see PRU 7.4.36 R);
(c) the present value of future profits (or losses) on any non-profit insurance contracts written in the with-profits fund (see PRU 7.4.37 R);
(d) the value of any derivative or quasi-derivative held in the fund (see PRU 1.3.11 R to PRU 1.3.30 R) to the extent its value is not reflected in (a), (b) or (c);
(e) any amount determined under (2); and
(f) the amount of any prepayments made from the fund.

(2) Where any equity shares held (directly or indirectly) by a firm (A):

(a) are shares in a related undertaking (B) which carries on long-term insurance business; and
(b) have been identified by A under PRU 7.4.21 R as long-term insurance assets which are held in the with-profits fund for which the realistic value is to be determined under (1);

the amount required under (1)(e) is the relevant proportion of the value of all B's equity shares as determined in (3).
(3) For the purposes of (2):

(a) the relevant proportion is the proportion of the total number of equity shares issued by B which are held (directly or indirectly) by A;
(b) the value of all B's equity shares must be taken as D deducted from C, where C is equal to the sum of:

(i) the shareholder net assets of B;
(ii) any surplus assets in the non-profit funds of B;
(iii) any additional amount arising from the excess of the present value of future profits (or losses) on any non-profit insurance contracts written by B (calculated on a basis consistent with PRU 7.4.37 R), excluding any amount arising from business that is written in a with-profits fund, over any present value of future profits (or losses) used in calculating B's regulatory capital requirements and arising from business outside its with-profits funds; and
(iv) where B has any with-profits funds, the present value of projected future transfers out of those funds to shareholder funds of B;
and D is equal to the sum of:
(v) the long-term insurance capital requirement in respect of any non-profit insurance contracts written in a non-profit fund of B;
(vi) the amount of the resilience capital requirement in respect of any non-profit insurance contracts written in a non-profit fund of B;
(vii) any part of the with-profits insurance capital component of B, to the extent that this is not covered from the assets of the with-profits fund from which it arises after deducting from those assets the amount calculated under (iv); and
(viii) any assets of B that back its regulatory capital requirements and that are valued in (iii) in the calculation of the present value of future profits of non-profit insurance business written by B.

(4) The methods and assumptions used in the calculations under (3)(b)(iii) and (iv) must follow a consistent approach to that set out in PRU 7.4.37 R.

31/12/2004

PRU 7.4.34

In PRU 7.4.33 R (1)(d), where a derivative or quasi-derivative has a positive asset value, credit should be given within the realistic value of assets. If the derivative or quasi-derivative has a negative asset value it should be valued within realistic liabilities as an element of realistic current liabilities (see PRU 7.4.40 R (3)).

31/12/2004

PRU 7.4.35

Where a firm identifies shares in a related undertaking which carries on long-term insurance business as shares held in one of its with-profits funds, PRU 7.4.33 R (1)(e), PRU 7.4.33 R (2) and PRU 7.4.33 R (3) bring in a realistic valuation of the related undertaking equal to its net assets plus the present value of future profits, less its regulatory capital requirements (see PRU 7.4.33 R (3)(v), (vi) and (vii)). Where the related undertaking has taken the present value of future profits arising from its contracts into consideration in covering its regulatory capital requirements (for example, its risk capital margin, under PRU 7.4.45 R (2)(c)), PRU 7.4.33 R (3)(b)(iii) requires a firm to exclude those future profits in valuing the related undertaking. The subtraction of the capital requirements in the calculation provides a straightforward method of allowing for the change in the related undertaking's value in stress conditions, as the value of the related undertaking is not subject to the realistic stress tests of the risk capital margin. In calculating the present value of future profits on non-profit insurance business written in the related undertaking under PRU 7.4.33 R (3)(b)(iii), a firm may value the release of capital requirements as the business runs off (see PRU 7.4.38 G). PRU 7.4.33 R (3)(b)(viii) ensures that any such capital is not double-counted.

31/12/2004

PRU 7.4.36

Excess admissible assets of a with-profits fund means admissible assets which exceed any of the percentage limits referred to in PRU 3.2.22 R.

31/12/2004

PRU 7.4.37

A firm must calculate the present value of future profits (or losses) on non-profit insurance contracts written in the with-profits fund using methodology and assumptions which:

(1) are based on current estimates of future experience;
(2) involve reasonable (but not excessively prudent) adjustments to reflect risk and uncertainty;
(3) allow for a market-consistent valuation of any guarantees or options within the contracts valued;
(4) are derived from current market yields;
(5) have regard to generally accepted actuarial practice and generally accepted industry standards appropriate for firms carrying on long-term insurance business;
(6) are consistent with the allocation, made in accordance with PRU 7.4.22 R, of any aggregate amounts as between the with-profits insurance contracts and the non-profit insurance contracts written in the fund;
(7) allow for any tax that would be payable out of the with-profits fund in respect of the contracts valued; and
(8) are consistent with the allocation, made in accordance with PRU 7.4.26 R, of long-term admissible assets as between the with-profits insurance contracts and any non-profit insurance contracts written in the fund.

31/12/2004

PRU 7.4.38

In calculating the present value of future profits (or losses) for non-profit insurance business required by PRU 7.4.33 R (1)(c), to the extent that the long-term insurance capital requirement and the resilience capital requirement are covered by the with-profits fund's long-term admissible assets, a firm may take into consideration any release of these items as the relevant policies go off the books.

31/12/2004

PRU 7.4.39

Annuities do not typically fall to be valued on a market-consistent basis under PRU 7.4.37 R (3) as they are not "options and guarantees" as defined for accounting purposes. This is because they do not have "time value" in the option-pricing meaning of that term. However where, atypically, annuities do fall to be valued on a market-consistent basis under PRU 7.4.37 R (3), the discount rate used should be appropriate to the characteristics of the liability, including its illiquidity. The appropriate interest rate, therefore, would not typically be the risk-free rate. Where illiquid assets are used to closely match similar illiquid liabilities, as could be the case in annuities business, it would be appropriate to look at the liquidity premium that is implicit in the market value of the assets as a proxy for the liquidity premium that should be included in a market consistent valuation of the liabilities. However, care should be exercised in doing this. Assets and liabilities are rarely perfectly matched and an appropriate margin needs to be included in the valuation to cover the risk of unexpected mismatch.

31/12/2004

Realistic value of liabilities: general

PRU 7.4.40

For the purposes of PRU 7.4.32 R (2)(a), the realistic value of liabilities of a with-profits fund is the sum of:

(1) the with-profits benefits reserve of the fund;
(2) the future policy related liabilities of the fund; and
(3) the realistic current liabilities of the fund.

31/12/2004

PRU 7.4.41

All liabilities arising under, or in connection with, with-profits insurance contracts written in the fund should be included in the realistic value of liabilities referred to in PRU 7.4.40 R, including those in respect of guarantees and the value of options.

31/12/2004

PRU 7.4.42

Detailed rules and guidance for the calculation of the three elements referred to in PRU 7.4.40 R are contained below in this section:

(1) PRU 7.4.116 R to PRU 7.4.135 G refer to the with-profits benefits reserve;
(2) PRU 7.4.136 G to PRU 7.4.189 G refer to the future policy related liabilities; and
(3) PRU 7.4.190 R and PRU 7.4.191 R refer to the realistic current liabilities.

31/12/2004

Risk capital margin

PRU 7.4.43

(1) A firm must calculate a risk capital margin for each of its with-profits funds in accordance with (2) to (6).
(2) The firm must identify relevant assets (PRU 7.4.45 R) which, in the most adverse scenario, will have a value (PRU 7.4.46 R) which is equal to the realistic value of liabilities of the fund under that scenario.
(3) The most adverse scenario means the single event comprising that combination of the scenarios in PRU 7.4.44 R which gives rise to the largest positive value that results from deducting B from A, where:

(a) A is the value of relevant assets which will produce the result described in (2); and
(b) B is the realistic value of liabilities of the fund.

(4) The risk capital margin for the fund is the result of deducting C from A, where C is the sum of:

(a) B; and
(b) any amount included within relevant assets under PRU 7.4.45 R (2)(c).

(5) In calculating the value of relevant assets for the purpose of determining the most adverse scenario in (3), a firm must not adjust the valuation of any asset taken into consideration under PRU 7.4.33 R (1)(e) (related undertakings carrying on long-term insurance business) or PRU 7.4.45 R (2)(c) (present value of future profits arising from insurance contracts written outside the with-profits fund).
(6) In calculating the realistic value of liabilities of a fund under any scenario, a firm is not required to adjust the best estimate provision made under PRU 7.4.190 R (1) in respect of a defined benefits pension scheme in accordance with PRU 7.4.191 R .

31/12/2004

PRU 7.4.44

For the purposes of PRU 7.4.43 R (3), the scenarios are one scenario selected from each of the following:

(1) in respect of UK and other assets within PRU 7.4.62 R (1)(a):

(a) the range of market risk scenarios identified in accordance with PRU 7.4.68 R (1) (equities);
(b) the range of market risk scenarios identified in accordance with PRU 7.4.68 R (2) (real estate); and
(c) the range of market risk scenarios identified in accordance with PRU 7.4.68 R (3) (fixed interest securities);

(2) in respect of non-UK assets within PRU 7.4.62 R (1)(b):

(a) the range of market risk scenarios identified in accordance with PRU 7.4.73 R (1) (equities);
(b) the range of market risk scenarios identified in accordance with PRU 7.4.73 R (2) (real estate); and
(c) the range of market risk scenarios identified in accordance with PRU 7.4.73 R (3) (fixed interest securities);

(3) the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (1) (bond or debt items);
(4) the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (2) (reinsurance items or analogous non-reinsurance financing agreements);
(5) the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (3) (other items including derivatives and quasi-derivatives); and
(6) the persistency risk scenario identified in accordance with PRU 7.4.100R.

31/12/2004

PRU 7.4.45

(1) In PRU 7.4.43 R, in relation to a with-profits fund, the relevant assets means a range of assets which meets the following conditions:

(a) the range is selected on a basis which is consistent with the firm's regulatory duty to treat its customers fairly;
(b) the range must include assets from within the with-profits fund the value of which is greater than or equal to the realistic value of liabilities of the fund;
(c) the range is selected in accordance with (2); and
(d) no asset of the firm may be allocated to the range of assets identified in respect of more than one with-profits fund.

(2) The range of assets must be selected from the assets specified in (a) to (c), in the order specified:

(a) assets that have a realistic value under PRU 7.4.33 R;
(b) where a firm has selected all the assets within (a), any admissible assets that are not identified as held within the with-profits fund; and
(c) where a firm has selected all the assets within (a) and (b), any additional assets.

(3) But a firm must not bring any amounts into account under (2)(b) or (2)(c) in respect of any with-profits fund if that would result in the firm exceeding its overall maximum limit (determined according to whether the firm has only one with-profits fund or more than one such fund).
(4) A firm exceeds its overall maximum limit for amounts brought into account under (2)(b) where:

(a) in the case of a firm with a single with-profits fund, the amount the firm brings into account in respect of that fund;
(b) in the case of a firm with two or more with-profits funds, the aggregate of the amounts the firm brings into account in respect of each of those funds;

exceeds the sum of the firm's shareholder net assets and the surplus assets in the firm's non-profits funds, less any regulatory capital requirements in respect of business written outside its with-profits funds.
(5) A firm exceeds its overall maximum limit for amounts brought into account under (2)(c) where:

(a) in the case of a firm with a single with-profits fund, the amount the firm brings into account in respect of that fund;
(b) in the case of a firm with two or more with-profits funds, the aggregate of the amounts the firm brings into account in respect of each of those funds;

exceeds 50% of the present value of future profits arising from insurance contracts written by the firm outside its with-profits funds.

31/12/2004

PRU 7.4.46

In valuing the relevant assets identified under PRU 7.4.43 R (2), a firm must use the same methods of valuation as in PRU 7.4.33 R, except that:

(1) the value of any admissible assets not identified as held within the with-profits fund (PRU 7.4.45 R (2)(b)) must be as determined under PRU 1.3; and
(2) the value of any asset which forms part of the range of assets as a result of PRU 7.4.45 R (2)(c) must be determined on a basis consistent with that described in PRU 7.4.37 R.

31/12/2004

PRU 7.4.47

The purpose of the risk capital margin for a with-profits fund is to cover adverse deviation from:

(1) the fund's realistic value of liabilities;
(2) the value of assets identified, in accordance with PRU 7.4.43 R (2), to cover the amount in (1) and the fund's risk capital margin;

arising from the effects of market risk, credit risk and persistency risk. Other risks are not explicitly addressed by the risk capital margin.

31/12/2004

PRU 7.4.48

The amount of the risk capital margin calculated by the firm for a with-profits fund will depend on the firm's choice of assets held to cover the fund's realistic value of liabilities and the margin. PRU 7.4.43 R requires the relevant assets to be sufficient, in the most adverse scenario, to cover the realistic value of liabilities in the event that scenario was to arise.

31/12/2004

PRU 7.4.49

PRU 7.4.45 R (2)(c) allows firms to bring the economic value of non-profit insurance business written outside a with-profits fund into the assets available to cover the risk capital margin. To place a prudent limit on the amount of future profits taken into consideration a maximum of 50% of the present value of non-profit insurance business can be taken into the calculation (PRU 7.4.45 R (5)). Where a contract is written in a non-profit fund but the assets arising from that contract are invested in a with-profits fund which is subject to charges for investment management or other services which benefit the non-profit fund, such charges can be taken into consideration in calculating the present value of future profits of the non-profit insurance business. Where a proportion of the present value of future profits on non-profit insurance business written outside a with-profits fund is brought in as an asset, no stress tests apply to this asset (see PRU 7.4.43 R (5)) as the amount taken into consideration is limited to 50% of the total present value.

31/12/2004

PRU 7.4.50

A firm using a stochastic approach in PRU 7.4.169 R (1) should keep recalibration in the post-stress scenarios to the minimum required to reflect any change in the underlying risk-free yields. A firm using the market costs of hedging approach, as in PRU 7.4.169 R (2), may assume in estimating the market cost of hedging in the post-stress scenarios that market volatilities are unchanged.

31/12/2004

PRU 7.4.51

In the scenario tests set out in PRU 7.4.62 R to PRU 7.4.103 G, firms are required to test for worst case scenarios across a range of assumptions. The tests are, with the exception of the credit risk test, two-sided, requiring both increases and decreases in the assumptions. The FSA does not expect a firm to investigate every possible stress, but a firm should be able to demonstrate that it is reasonable to assume that it has successfully identified the single event that determines the risk capital margin for the firm's business, as required by PRU 7.4.43 R (3).

31/12/2004

Management actions

PRU 7.4.52

In calculating the risk capital margin for a with-profits fund, a firm may reflect, in its projections of the value of assets and liabilities under the scenarios in PRU 7.4.44R, the firm's prospective management actions (PRU 7.4.53 R).

31/12/2004

PRU 7.4.53

Prospective management actions refer to the foreseeable actions that would be taken by the firm's management, taking into account:

(1) an appropriately realistic period of time for the management actions to take effect; and
(2) the firm's PPFM and its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.54

The management actions in PRU 7.4.53 R may include, but are not limited to, changes in future bonus rates, reductions in surrender values, changes in asset dispositions (taking into account the associated selling costs) and changes in the amount of charges deducted from asset shares for with-profits insurance contracts.

31/12/2004

PRU 7.4.55

A firm should use reasonable assumptions in incorporating management actions into its projections of claims such that the mitigating effects of the management actions are not overstated. In modelling management actions, a firm should ensure consistency with its PPFM and take into account its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.56

In accordance with PRU 7.4.17 R, a firm should make and retain a record of the approach used, in particular the nature and effect of anticipated management actions (including, where practicable, the amount by which the actions would serve to reduce the projected values of assets and liabilities).

31/12/2004

PRU 7.4.57

A firm which deducts charges in respect of any adverse experience or cost of capital to with-profits insurance contracts should keep a record under PRU 7.4.17 R of the amount of any such charges to its customers and of how it has ensured their fair treatment.

31/12/2004

Policyholder actions

PRU 7.4.58

In calculating the risk capital margin for a with-profits fund, a firm must reflect, in its projections of the value of assets and liabilities under the scenarios in PRU 7.4.44 R, a realistic assessment of the actions of its policyholders (see PRU 7.4.59 R).

31/12/2004

PRU 7.4.59

Policyholder actions refer to the foreseeable actions that would be taken by the firm's policyholders, taking into account:

(1) the experience of the firm in the past; and
(2) the changes that may occur in the future if options and guarantees become more valuable to policyholders than in the past.

31/12/2004

PRU 7.4.60

A firm should use realistic assumptions in incorporating policyholder actions into its projections of claims such that any mitigating effects of policyholder actions are not overstated and any exacerbating effects of policyholder actions are not understated. In modelling policyholder actions, a firm should ensure consistency with its PPFM and take into account its regulatory duty to treat its customers fairly in determining the options and information that would be available to policyholders.

31/12/2004

PRU 7.4.61

In calculating the persistency scenario in PRU 7.4.100 R, a firm needs to make assumptions regarding the future termination rates exhibited by policies, at points described in particular in PRU 7.4.101 R. Such assumptions should be realistic. However, the firm must have regard to the economic scenarios being projected. For example, if the value of an option became significantly greater in a future scenario than in the recent past, then the behaviour of policyholders in taking up the option is likely to differ in this future scenario compared with the recent past.

31/12/2004

Market risk scenario

PRU 7.4.62

(1) For the purposes of PRU 7.4.44 R, the ranges of market risk scenarios that a firm must assume are:

(a) for exposures to UK assets and for exposures to non-UK assets within (2), the ranges of scenarios set out in PRU 7.4.68 R; and
(b) for exposures to other non-UK assets, the ranges of scenarios set out in PRU 7.4.73 R.

(2) The exposures to non-UK assets within this paragraph are:

(a) exposures which do not arise from a significant territory outside the United Kingdom (PRU 7.4.63 R); or
(b) exposures which do arise from a significant territory outside the United Kingdom but which represent less than 0.5% of the realistic value of assets of the with-profits fund, measured by market value.

31/12/2004

PRU 7.4.63

For the purposes of this section in relation to a with-profits fund, a significant territory is any country or territory in which more than 2.5% of the fund's realistic value of assets (by market value) are invested.

31/12/2004

PRU 7.4.64

In determining its most adverse scenario, a firm applying PRU 7.4.68 R and PRU 7.4.73 R should consider separately possible movements in UK and non-UK markets. It should not assume that market prices in different markets move in a similar way at the same time. A firm should also allow for the effect of the other components of the single event comprising the combination of scenarios applicable under PRU 7.4.43 R.

31/12/2004

PRU 7.4.65

In relation to the market risk scenarios in PRU 7.4.68 R and PRU 7.4.73 R, the effect of PRU 7.4.52 R and PRU 7.4.58 R is that a firm may reflect management actions and must make a realistic assessment of policyholder actions in projecting the assets and liabilities in its calculation of the risk capital margin for a with-profits fund within the firm. This contrasts with the position for calculating the resilience capital requirement for the firm (PRU 4.2.9 G to PRU 4.2.26 R).

31/12/2004

PRU 7.4.66

In PRU 7.4.62 R to PRU 7.4.76 G, where there is reference to exposure to assets invested in a territory this should be interpreted as follows:

(1) for equities, a stock that is listed on a stock market in that territory or, if unlisted, the stock of a company that is incorporated in that territory;
(2) for bonds, one that is denominated in the currency of that territory, or issued by an institution incorporated in that territory;
(3) for real estate, a property that is located in that territory; and
(4) for derivatives, quasi-derivatives and other instruments, one where the assets to which the instrument is exposed are assets invested in that territory.

In PRU 7.4.62 R to PRU 7.4.76 G, a preference share should be subjected to the same stress tests as an equity share.

31/12/2004

PRU 7.4.67

The relevant assets identified under PRU 7.4.43 R (2) to calculate the risk capital margin may, in certain circumstances, include up to 50% of the present value of future profits arising from insurance contracts written by the firm outside its with-profits funds. PRU 7.4.43 R (5) exempts such an asset from the market risk stress tests.

31/12/2004

Market risk scenario for exposures to UK assets and certain non-UK assets

PRU 7.4.68

The range of market risk scenarios referred to in PRU 7.4.62(1)(a) is:

(1) a rise or fall in the market value of equities of up to the greater of:

(a) 10%; and
(b) 20%, less the equity market adjustment ratio (see PRU 7.4.71 R);

(2) a rise or fall in real estate values of up to 12.5%; and
(3) a rise or fall in yields on all fixed interest securities of up to 17.5% of the long-term gilt yield.

31/12/2004

PRU 7.4.69

For the purposes of PRU 7.4.68 R, a firm must:

(1) assume that yields on equities and real estate remain unchanged from those applicable at market levels before applying each scenario; and
(2) model a rise or fall in equity, real estate and fixed interest markets as if the movement occurred instantaneously.

31/12/2004

PRU 7.4.70

For example, where the long-term gilt yield is 6%, a change of 17.5% in that yield would amount to a change of 1.05 percentage points. For the purpose of the scenarios in PRU 7.4.68 R (3), the firm would assume a fall or rise of up to 1.05 percentage points in yields on all fixed interest securities.

31/12/2004

Equity market adjustment ratio

PRU 7.4.71

The equity market adjustment ratio referred to in PRU 7.4.68 R (1)(b) is:

(1) if the ratio calculated in (a) and (b) lies between 80% and 100%, the result of 100% less the ratio (expressed as a percentage) of:

(a) the current value of the FTSE Actuaries All Share Index; to
(b) the average value of the FTSE Actuaries All Share Index over the preceding 90 calendar days;

(2) 0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and
(3) 20%, if the ratio calculated in (1)(a) and (b) is less than 80%.

31/12/2004

PRU 7.4.72

In PRU 7.4.71(1)(b), the average value of the FTSE Actuaries All Share Index over any period of 90 calendar days means the arithmetic mean based on levels at the close of business on each of the days in that period on which the London Stock Exchange was open for trading.

31/12/2004

Market risk scenario for exposures to other non-UK assets

PRU 7.4.73

The range of market risk scenarios referred to in PRU 7.4.62 R (1)(b) is:

(1) an appropriate rise or fall in the market value of equities listed in that territory (PRU 7.4.75 G), which must be at least equal to the percentage determined in PRU 7.4.68 R (1);
(2) a rise or fall in real estate values in that territory of up to 12.5%; and
(3) a rise or fall in yields on all fixed interest securities of up to 17.5% of the nearest equivalent (in respect of the method of calculation) of the long-term gilt yield.

31/12/2004

PRU 7.4.74

For the purposes of PRU 7.4.73 R, a firm must:

(1) assume that yields on equities and real estate remain unchanged from those applicable at market levels before applying each scenario; and
(2) model a rise or fall in equity, real estate and fixed interest markets as if the movement occurred instantaneously.

31/12/2004

PRU 7.4.75

For the purposes of PRU 7.4.73 R (1), an appropriate rise or fall in the market value of equities to which a firm has exposure in a significant territory must be determined having regard to:

(1) an appropriate equity market index (or indices) for that territory; and
(2) the historical volatility of the equity market index (or indices) selected in (1).

31/12/2004

PRU 7.4.76

For the purpose of PRU 7.4.75 G (1), an appropriate equity market index (or indices) for a territory should be such that:

(1) the constituents of the index (or indices) are reasonably representative of the nature of the equities to which the firm is exposed in that territory which are included in the relevant assets identified in accordance with PRU 7.4.43 R (2); and
(2) the frequency of, and historical data relating to, published values of the index (or indices) are sufficient to enable an average value(s) and historical volatility of the index (or indices) to be calculated over at least the three preceding financial years.

31/12/2004

General

PRU 7.4.77

(1) The purpose of the credit risk scenarios in PRU 7.4.78 R to PRU 7.4.99 G is to show the financial effect of specified changes in the general credit risk environment on a firm's direct (counterparty) and indirect credit risk exposures. The scenarios apply in relation to corporate bonds, debt, reinsurance and other exposures, including derivatives and quasi-derivatives. This is thus quite separate from any reference to allowance for credit risk in PRU 4.2.
(2) In the case of bonds and debts, the scenarios are described in terms of an assumed credit rating dependent on the widening of credit spreads - changes in bond and debt credit spreads will have a direct impact on the value of bond and debt assets. Credit ratings are intended to give an indication of the security of the income and capital payments for a bond - the higher the credit rating, the more secure the payments. The reaction of credit spreads to developments in markets for credit risk varies by credit rating and so the scenarios to be assumed for bonds and debts depend on their ratings. The credit spreads on bonds and debt represent compensation to the investor for the risk of default and downgrade, but also for illiquidity, price volatility and the uncertainty of recovery rates relative to government bonds. Credit spreads on bonds tend to widen during an economic recession to reflect the increased expectations that corporate borrowers may default on their obligations or be subject to rating downgrades.
(3) Changes in bond and debt credit spreads will also be indicative of a change in direct counterparty exposure in relation to reinsurance and other exposures including derivatives and quasi-derivatives.
(4) In addition, changes in bond and debt credit spreads may indirectly impact on credit exposures, for example by affecting the payments anticipated under credit derivative instruments.
(5) A firm will also need to allow for the effect of other components of the single event comprising the combination of scenarios applicable under PRU 7.4.43 R in assessing exposure to credit risk. For example, in the case of an equity put option and a fall in equity market values, the resulting increase in the level of exposure to the firm's counterparty for the option combined with a change in the quality of the counterparty should be allowed for.

31/12/2004

PRU 7.4.78

For the purposes of PRU 7.4.44 R, the range of credit risk scenarios that a firm must assume is:

(1) changes in value resulting from an increase in credit spreads by an amount of up to the spread stress determined according to PRU 7.4.84 R in respect of any bond or debt item;
(2) changes in value determined according to PRU 7.4.94 R in respect of any reinsurance item or any analogous non-reinsurance financing agreement item; and
(3) changes in value determined according to PRU 7.4.98 R for any other item (including any derivative or quasi-derivative).

31/12/2004

PRU 7.4.79

For the purposes of PRU 7.4.78 R, a firm must make appropriate allowance for any loss mitigation techniques to the extent that they are loss mitigation techniques relied on for the purpose of PRU 3.2.8 R in accordance with PRU 3.2.16 R and PRU 3.2.18 R.

31/12/2004

PRU 7.4.80

The change in asset or liability values to be determined in relation to a credit risk scenario for the purposes of PRU 7.4.43 R and PRU 7.4.44 R is the change in value which would arise on the occurrence of the relevant credit risk scenario as a result of bond, debt, reinsurance or other exposures whether or not there is a direct counterparty exposure.

31/12/2004

PRU 7.4.81

Where a bond or a debt item or reinsurance asset is currently in default, it may be ignored by a firm for the purpose of applying PRU 7.4.78 R.

31/12/2004

PRU 7.4.82

Where a bond or a debt item or a reinsurance asset is currently in default and has been specifically provisioned, in accordance with relevant accounting standards, a firm is not required to increase the existing default provisions to reflect a worsening of recovery rates.

31/12/2004

PRU 7.4.83

Where the credit risk scenarios in PRU 7.4.78 R to PRU 7.4.99 G require a firm to assume a change in current credit spread, or a direct change in market value, the firm must not change the risk-free yields used to discount future cash flows in calculating the revised realistic value of liabilities and realistic value of assets (PRU 7.4.43 R (2)) resulting from those credit risk scenarios.

31/12/2004

Spread stresses to be assumed for bonds and debt

PRU 7.4.84

(1) In PRU 7.4.78 R (1) the spread stress which a firm must assume for any bond or debt item is:

(a) for any bond or debt item issued or guaranteed by an organisation which is in accordance with PRU 7.4.87 R a credit risk scenario exempt organisation in respect of that item, zero basis points; and
(b) for any other bond or debt item:

(i) Y if the credit rating description of that other bond or debt item determined by reference to PRU 7.4.89 R is not "Highly speculative or very vulnerable"; and
(ii) otherwise the larger of Y and Z.

(2) For the purpose of (1)(b):

(a) Y is the product of the spread factor for that bond or debt item and the square root of S, where:

(i) the spread factor for a bond or debt item is the spread factor shown in the final column of Table PRU 7.4.90 R, in the row of that Table corresponding to the credit rating description of the bond or debt item determined for the purpose of this rule by reference to PRU 7.4.89 R; and
(ii) subject to (3), S is the current credit spread for a bond or debt item, expressed as a number of basis points, which the firm must determine as the current yield on that bond or debt item in excess of the current gross redemption yield on the government bond most similar to that bond or debt item in terms of currency of denomination and equivalent term; and

(b) Z is the change in credit spread expressed as a number of basis points that would result in the current market value of the bond or debt falling by 5%.

(3) Where, for the purposes of (2)(a)(ii), there is no suitable government bond, the firm must use its best estimate of the gross redemption yield that would apply for a notional government bond similar to the bond or debt item in terms of currency of denomination and equivalent term.

31/12/2004

PRU 7.4.85

For the purpose of PRU 7.4.84 R (1)(a), a guarantee must be direct, explicit, unconditional and irrevocable.

31/12/2004

PRU 7.4.86

(1) As an example, a bond item has the credit rating description "exceptional or extremely strong" and currently yields 49 basis points in excess of the most similar government bond. The spread factor for that bond item is 3.00 by reference to Table PRU 7.4.90 R. Since S is 49, the square root of S is 7 and the spread stress for that item is 3 times 7, that is, 21 basis points. The firm must consider the impact of an increase in spreads by up to 21 basis points for that item.
(2) As a further example, a bond item has the credit rating description "highly speculative or very vulnerable". For this bond, S is 400, being the current spread for that bond expressed as a number of basis points. The spread factor for the bond is 24.00. So the firm must consider the impact of an increase in spreads by up to 24.00 times 20 i.e. 480 basis points for that item. The bond is however of short duration and the reduction in market value resulting from an additional spread of 480 basis points is less than 5 per cent of its current market value. A 5 per cent reduction in its market value would result from a spread widening of 525 basis points. The firm must consider the impact of an increase in spreads by up to 525 basis points for that item by virtue of its credit rating description.
(3) The calculation of the credit spread on commercial floating rate notes warrants particular consideration. Suppose, for example, that a notional floating rate note guaranteed by the UK government would have a market consistent price of X. This price can be estimated based on an assumed distribution of future payments under the floating rate note, and the current forward gilt curve. Suppose further that the market price of the commercial floating rate note is Y, where Y is less than X. A firm could calculate what parallel upward shift in the forward gilt curve would result in the notional government-backed floating rate note having a market price of Y for an unchanged assumed distribution of future payments. The size of the resulting shift could then be taken as the credit spread on the commercial floating rate note.
(4) In arriving at the estimated gross redemption yield in PRU 7.4.84 R (3), the firm may have regard to any appropriate swap rates for the currency of denomination of the bond or debt item, adjusted to take appropriate account of observed differences between swap rates and the yields on government bonds.

31/12/2004

PRU 7.4.87

For the purposes of this section:

(1) an organisation is a credit risk scenario exempt organisation in respect of an item if the organisation is:

(a) the European Central Bank; or
(b) any central government or central bank which, in relation to that item, satisfies the conditions in (2); or
(c) a multilateral development bank which is listed in (3); or
(d) an international organisation which is listed in (4);

(2) the conditions in (1)(b) are that, for any claim against the central government or central bank denominated in the currency in which the item is denominated:

(a) a credit rating is available from at least one listed rating agency nominated in accordance with PRU 7.4.92 R; and
(b) the credit rating description in the first column of Table PRU 7.4.90 R corresponding to the lowest such credit rating is either "exceptionally or extremely strong" or "very strong";

(3) for the purposes of (1)(c) the listed multilateral development banks are:

(a) the International Bank for Reconstruction and Development;
(b) the International Finance Corporation;
(c) the Inter-American Development Bank;
(d) the Asian Development Bank;
(e) the African Development Bank;
(f) the Council of Europe Development Bank;
(g) the Nordic Investment Bank;
(h) the Caribbean Development Bank;
(i) the European Bank for Reconstruction and Development;
(j) the European Investment Bank;
(k) the European Investment Fund; and
(l) the Multilateral Investment Guarantee Agency;

(4) for the purposes of (1)(d) the listed international organisations are:

(a) the European Community;
(b) the International Monetary Fund; and
(c) the Bank for International Settlements.

31/12/2004

PRU 7.4.88

Under PRU 7.4.87 R (2), a firm needs to take account of the currency in which the claim is denominated when it is considering claims on or guaranteed by a central government or central bank. It is possible, for example, that a given central bank would be a credit risk scenario exempt organisation in respect of claims on it denominated in its domestic currency, while not being a credit risk scenario exempt organisation in respect of claims on it denominated in a currency other than its domestic currency - the central government or central bank may have been assigned different credit assessments depending on the currency in which the claim on it is denominated.

31/12/2004

PRU 7.4.89

(1) For the purposes of this section, the credit rating description of a bond or debt item is to be determined in accordance with (2) and (3).
(2) If the item has at least one credit rating nominated in accordance with PRU 7.4.92 R ("a rated item"), its credit rating description is:

(a) where it has only one nominated credit rating, the general description given in the first column of Table PRU 7.4.90 R corresponding to that rating; or
(b) where it has two or more nominated credit ratings and the two highest nominated ratings fall within the same general description given in the first column of that Table, that description; or
(c) where it has two or more nominated credit ratings and the two highest nominated ratings do not fall within the same general description given in the first column of that Table, the second highest of those two descriptions.

(3) If the item is not a rated item, its credit rating description is the general description given in the first column of Table PRU 7.4.90 R that most closely corresponds to the firm's own assessment of the item's credit quality.
(4) An assessment under (3) must be made by the firm for the purposes of the credit risk scenario having due regard to the seniority of the bond or debt and the credit quality of the bond or debt issuer.

31/12/2004

PRU 7.4.90

Table : Listed rating agencies, credit rating descriptions, spread factors

Credit Rating Description

Listed rating agencies

Spread Factor

A.M. Best Company

Fitch Ratings

Moody's Investors Service

Standard & Poor's Corporation

Exceptional or extremely strong

aaa

AAA

Aaa

AAA

3.00

Very strong

5.25

Strong

6.75

Adequate

bbb

BBB

Baa

BBB

9.25

Speculative or less vulnerable

15.00

Very speculative or more vulnerable

24.00

Highly speculative or very vulnerable

Below B

24.00

31/12/2004

PRU 7.4.91

Where listed rating agencies provide ratings by sub-category then all ratings should be allocated to the main ratings category (e.g. ratings sub-category A+ or A- would be allocated to the assigned ratings category "Strong").

31/12/2004

PRU 7.4.92

For the purposes of PRU 7.4.87 R and PRU 7.4.89 R, a firm may, subject to (1) to (5), nominate for use credit ratings produced by one or more of the rating agencies listed in PRU 7.4.93 R:

(1) if the firm decides to nominate for use for an item the credit rating produced by one or more rating agencies, it must do so consistently for all similar items;
(2) the firm must use credit ratings in a continuous and consistent way over time;
(3) the firm must nominate for use only credit ratings that take into account both principal and interest;
(4) if the firm nominates for use credit ratings produced by one of the listed rating agencies then the firm must use solicited credit ratings produced by that listed rating agency; and
(5) the firm may nominate for use unsolicited credit ratings produced by one or more of the listed rating agencies except where there are reasonable grounds for believing that any unsolicited credit ratings produced by the agency are used so as to obtain inappropriate advantages in the relationship with rated parties.

31/12/2004

PRU 7.4.93

In this section, a listed rating agency is:

(1) A.M. Best Company; or
(2) Fitch Ratings; or
(3) Moody's Investors Service; or
(4) Standard & Poor's Corporation.

31/12/2004

Credit risk scenario for reinsurance

PRU 7.4.94

(1) The contracts of reinsurance or analogous non-reinsurance financing agreements to which PRU 7.4.78 R (2) applies are those:

(a) into which the firm has entered;
(b) which represent an economic asset under the single event applicable under PRU 7.4.43 R (3); and
(c) which are material (individually or in aggregate).

(2) For the purposes of (1), no account is to be taken of reinsurance or analogous non-reinsurance financing arrangements between undertakings in the same group where:

(a) the ceding and accepting undertakings are regulated by the FSA or a regulatory body in a designated State or territory for insurance (including reinsurance);
(b) no subsequent cessions of the ceded risk which are material (individually or in aggregate) are made to subsequent accepting undertakings by accepting undertakings (including subsequent accepting undertakings) other than to subsequent accepting undertakings which are in the same group; and
(c) for any subsequent cession or cessions of the ceded risk which are material (individually or in aggregate) each of the ceding and accepting undertakings (including subsequent accepting undertakings) is regulated by the FSA or a regulatory body in a designated State or territory for insurance (including reinsurance).

(3) The change in value which a firm must determine for a contract of reinsurance or an analogous non-reinsurance financing agreement is the firm's best estimate of the change in realistic value which would result from changes in credit risk market conditions consistent, subject to (4), with the changes in credit spreads determined in accordance with PRU 7.4.78 R (1).
(4) For the purpose of (3), 5% should be replaced by 10% in PRU 7.4.84 R (2)(b).

31/12/2004

PRU 7.4.95

(1)Reinsurance and analogous non-reinsurance financing agreements entered into by the firm, either with or acting as a reinsurer, must be included within the scope of the scenario. The combined rights and obligations under a contract of reinsurance or an analogous non-reinsurance financing agreement may represent an economic asset or liability. The value placed by the firm on the reinsurance item or non-reinsurance financing item should allow for a realistic assessment of the risks transferred and the risks of counterparty default associated with the item. In the case of analogous non-reinsurance financing agreements, references to terms such as "reinsurer", "ceding undertakings" and "accepting undertakings" include undertakings which by analogy are reinsurers, ceding or accepting undertakings. Analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.
(2) In assessing values in accordance with PRU 7.4.94 R, a firm may consider it appropriate to determine values by drawing an analogy with the approach in respect of bond and debt items set out in PRU 7.4.84 R. (This might be the case if, in economic terms, the item being valued sufficiently resembles a bond or debt item - an alternative approach might otherwise be preferred). If the firm does consider it appropriate to draw an analogy, the "credit spread" assumed should be consistent with the assumed default probabilities and the values placed on the reinsurance asset for the purposes of determining the realistic values of assets and liabilities. A firm may regard it as appropriate to have regard to any financial strength ratings applicable to the reinsurer, but if so should apply the same principles set out in PRU 7.4.92 R for the nomination of financial strength ratings. Table PRU 7.4.97 G provides guidance as to the allocation of spread factors which a firm may, by analogy, deem appropriate to apply. Appropriate allowance should be made for any change in the extent of the counterparty exposure under the assumed scenario.
(3) The changes in credit risk spreads determined for bond and debt items in accordance with PRU 7.4.78 R (1) are required to result in a reduction in market value for some items of 5% of their current value through the operation of PRU 7.4.84 R (2)(b). For reinsurance contracts and analogous non-reinsurance financing agreements, determining the change in value by reference to PRU 7.4.94 R (3) requires a firm to consider the possibility of counterparty default in changed credit risk market conditions. Where in the changed credit risk market conditions assumed to apply the firm's assessment of the counterparty risk would result in the asset being considered equivalent to "Highly speculative or very vulnerable", the reduction in value required is at least 10% of its current value. PRU 7.4.94 R (4) relates to this requirement.

31/12/2004

PRU 7.4.96

A financial strength rating of a reinsurer refers to a current assessment of the financial security characteristics of the reinsurer with respect to its ability to pay claims under its reinsurance contracts and treaties in accordance with their terms.

31/12/2004

PRU 7.4.97

Table: Listed rating agencies, financial strength descriptions and spread factors

Financial Strength Description

A.M. Best Company

Fitch Ratings

Moody's Investors Service

Standard & Poor's Corporation

Spread Factor

Superior, extremely strong

A++

AAA

Aaa

AAA

3.00

Superior, very strong

A+

5.25

Excellent or strong

A, A-

6.75

Good

B++,B+

BBB

Baa

BBB

9.25

Fair, marginal

B, B-

15.00

Marginal, weak

C++,C+

24.00

Unrated or very weak

Unrated or below C++,C+

Unrated or below B

24.00

31/12/2004

Credit risk scenario for other exposures (including any derivative or quasi-derivative)

PRU 7.4.98

For the purposes of PRU 7.4.78 R (3), the change in value which must be determined for any other item (including any derivative or quasi-derivative) which represents an economic asset under the single event applicable under PRU 7.4.43 R (3) is the firm's best estimate of the change in the realistic value of that item which would result from changes in credit risk market conditions consistent with the changes in credit spreads determined in accordance with PRU 7.4.78 R (1) and the changes in value determined in accordance with PRU 7.4.78 R (2).

31/12/2004

PRU 7.4.99

In applying PRU 7.4.98 R, a firm should assess the total impact on the value of the item resulting from the assumed changed credit risk market conditions. The total change in value may result from the interaction of a number of separate influences. For example, a widening of credit spreads may imply an impact on the amount exposed to counterparty default as well as on the likelihood of that default. Each factor influencing the change in value needs separate consideration. It should be assumed, both for determining amounts exposed to counterparty default and the likelihood of such default that there will be no change in the likelihood of default in relation to an item issued by or guaranteed by an organisation which is in respect of that item a credit risk scenario exempt organisation (PRU 7.4.87 R). PRU 7.4.77 G (5) is also relevant in this context.

31/12/2004

Persistency risk scenario

PRU 7.4.100

For the purposes of the persistency risk scenario in PRU 7.4.44 R (6), a firm must allow for the effects of an increase or a decrease in persistency experience of its with-profits insurance contract by adjusting the termination rates in each year of projection by 32.5% of the termination rates assumed in the calculation of the realistic value of liabilities in PRU 7.4.40 R.

31/12/2004

PRU 7.4.101

The termination rates referred to in PRU 7.4.100 R are the rates of termination (including the paying-up of policies, but excluding deaths, maturities and retirements) other than on dates specified by the firm where:

(1) a guaranteed amount applies as the minimum amount which will be paid on claim; or
(2) any payments to the policyholder cannot be reduced at the discretion of the firm by its applying a market value adjustment.

31/12/2004

PRU 7.4.102

For the purposes of PRU 7.4.100 R, the increase or decrease in termination rates must be applied to the projection of terminations up to policy guarantee dates and between policy guarantee dates, but not to the assumptions as to the proportion of policyholders taking up the guarantees at policy guarantee dates.

31/12/2004

PRU 7.4.103

PRU 7.4.100 R to PRU 7.4.102 R require firms to apply a persistency stress test to the realistic value of liabilities. Where a firm brings the present value of non-profit insurance business in a with-profits fund into the calculation of the realistic value of assets (see PRU 7.4.33R) there is no requirement to stress this asset for changes in persistency assumptions.

31/12/2004

Realistic value of liabilities: detailed provisions

PRU 7.4.104

PRU 7.4.40 R sets out the three elements comprising the realistic value of liabilities for a with-profits fund. The remainder of this section contains general rules and guidance on determining the realistic value of liabilities plus further detail relating to each of those elements separately, as follows:

(1) general rules and guidance in PRU 7.4.105 R to PRU 7.4.115 G;
(2) with-profits benefits reserve in PRU 7.4.116 R to PRU 7.4.135 G;
(3) future policy related liabilities in PRU 7.4.136 G to PRU 7.4.189 G; and
(4) realistic current liabilities in PRU 7.4.190 R and PRU 7.4.191 R.

31/12/2004

Methods and assumptions: general

PRU 7.4.105

In calculating the realistic value of liabilities for a with-profits fund, a firm must use methods and assumptions which:

(1) are appropriate to the business of the firm;
(2) are consistent from year to year without arbitrary changes (that is, changes without adequate reasons);
(3) are consistent with the method of valuing assets (PRU 1.3 );
(4) make full provision for tax payable out of the with-profits fund, based on current legislation and practice, together with any known future changes, and on a consistent basis with the other methods and assumptions used;
(5) take into account discretionary benefits which are at least equal to, and charges which are no more than, the levels required for the firm to fulfil its regulatory duty to treat its customers fairly;
(6) take into account prospective management actions (PRU 7.4.53 R) and policyholder actions (PRU 7.4.59 R);
(7) provide for shareholder transfers out of the with-profits fund as a liability of the fund;
(8) have regard to generally accepted actuarial practice; and
(9) are consistent with the firm's PPFM.

31/12/2004

PRU 7.4.106

More specific rules and guidance are set out below on some aspects of the methods and assumptions to be used in calculating the realistic value of liabilities for a with-profits fund. In contrast to the mathematical reserves requirements in PRU 7.3.10 R (4) and PRU 7.3.13 R, there is no requirement to include margins for adverse deviation of relevant factors in calculating the realistic value of liabilities. Assumptions need be no more prudent than is necessary to achieve a best estimate, taking into account the firm's PPFM and its regulatory duty to treat its customers fairly. Where there is no requirement for a PPFM, for example non-UK business, a firm should use assumptions that are consistent with the firm's documented approach to treating its customers fairly. A firm may judge that a margin should be included in its calculations to avoid an understatement of the realistic value of liabilities as a result of uncertainty, for example, either in its method or in its data.

31/12/2004

PRU 7.4.107

The amount and timing of tax charges affect the amount of assets available to meet policyholder liabilities. PRU 7.4.105 R (4) requires firms to provide fully for all tax payable out of the with-profits fund on a basis consistent with the other assumptions and methods used in deriving the realistic balance sheet. So, for example, all projections which underlie the realistic valuation of assets or liabilities must allow for taxation. The approach adopted should not give any credit for any reduction in tax deriving from future expenses or deficits which is attributable to future new business. For assets backing capital requirements it is not necessary to take into consideration future tax charges on investment income generated by those assets. However, firms should consider this aspect in their capital planning.

31/12/2004

PRU 7.4.108

PRU 7.4.105 R (7) requires firms to provide fully for shareholder transfers. Such transfers do not therefore count as capital in the with-profits fund. However, a firm may apply under section 148 of the Act for a waiver from this requirement. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether a firm has put in place undertakings satisfactory to the FSA, including that future transfers will not be paid out of the firm by way of dividend.

31/12/2004

Valuation of contracts: General

PRU 7.4.109

(1) A firm must determine the amount of the with-profits benefits reserve or the future policy related liabilities for a with-profits fund by carrying out a separate calculation in relation to each with-profits insurance contract or for each group of similar contracts.
(2) Appropriate approximations or generalisations may be made where they are likely to provide the same, or a higher, result than a separate calculation for each contract.
(3) A firm must set up additional reserves on an aggregated basis for general risks which are not specific to individual contracts or a group of similar contacts where the firm considers the realistic value of liabilities may otherwise be understated.

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PRU 7.4.110

For the purpose of PRU 7.4.109 R (1), a group of similar contracts is such that the conditions in PRU 7.4.109 R (2) are satisfied.

31/12/2004

PRU 7.4.111

Where a firm has grouped individual contracts for the purpose of calculating the mathematical reserves for a with-profits fund (in accordance with PRU 7.3.22 R), the firm is not required to use the same grouping of contracts in calculating the with-profits benefits reserve or future policy related liabilities for that fund.

31/12/2004

PRU 7.4.112

In contrast to PRU 7.3.24 R for the mathematical reserves, treating individual contracts as an asset is not prohibited if, and to the extent that, this treatment does not conflict with a firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.113

In calculating the with-profits benefits reserve, an overall (grouped or pooled) approach may be appropriate under either of the two methods set out in PRU 7.4.116 R. In particular, the calculation of aggregate retrospective reserves (see PRU 7.4.118 R) and the projection of future cash flows (see PRU 7.4.128 R) based on suitable specimen policies is permitted.

31/12/2004

PRU 7.4.114

In calculating the future policy related liabilities, the grouping of policies for valuing the costs of guarantees, options or smoothing, and their representation by representative policies, is acceptable provided the firm can demonstrate that the grouping of policies does not materially misrepresent the underlying exposure and does not significantly misstate the costs. A firm should exercise care in grouping policies in order to ensure that the risk exposure is not inappropriately distorted by, for example, forming groups containing policies with guarantees that are "in the money" and policies with guarantees well "out of the money". A firm should also have regard to the effects of policyholder behaviour over time on the spread of the outstanding guarantees or options.

31/12/2004

PRU 7.4.115

Where a firm groups similar policies for the purpose of calculating the with-profits benefits reserve or the future policy related liabilities, the firm should carry out sufficient validation to be reasonably sure that the grouping of policies has not resulted in the loss of any significant attributes of the portfolio being valued.

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With-profits benefits reserve

PRU 7.4.116

A firm must calculate a with-profits benefits reserve for a with-profits fund using either:

(1) a retrospective calculation under PRU 7.4.118 R (the retrospective method); or
(2) a prospective calculation under PRU 7.4.128 R of all future cash flows expected to arise under, or in respect of, each of the with-profits insurance contracts written in that fund (the prospective method).

31/12/2004

PRU 7.4.117

Subject to PRU 7.4.105 R (2), a firm may use different methods under PRU 7.4.116 R for different types or generations of with-profits insurance contracts.

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Retrospective method

PRU 7.4.118

In the retrospective method of calculating a with-profits benefits reserve, a firm must calculate either the aggregate of the retrospective reserves in respect of each with-profits insurance contract or, to the extent permitted by PRU 7.4.109 R and PRU 7.4.110 R, the total retrospective reserve in respect of each group of with-profits insurance contracts.

31/12/2004

PRU 7.4.119

In calculating the retrospective reserve for a with-profits insurance contract, or the total retrospective reserve in respect of a group of with-profits insurance contracts, a firm must take account of at least the following:

(1) premiums received from the policyholder;
(2) any expenses incurred or charges made (including commissions);
(3) any partial benefits paid or due;
(4) any investment income on, and any increases (or decreases) in, asset values;
(5) any tax paid or payable;
(6) any amounts received (or paid) under contracts of reinsurance or analogous non-reinsurance financing agreements, where relevant to retrospective reserves;
(7) any shareholder transfers and any associated tax paid or payable; and
(8) any permanent enhancements to (or deductions from) the retrospective reserves made by the firm.

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PRU 7.4.120

In taking account of amounts in PRU 7.4.119 R (6), due regard should be had to the specific details of each relevant contract of reinsurance or analogous non-reinsurance financing agreement and the relationship between the amounts received (or paid) and the value of the benefit granted (or received) under the arrangement. This should take into consideration, for example, the risk of default and differences in the firm's realistic assessment of the risks transferred and the contractual terms for such transfer of risk. Analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

31/12/2004

PRU 7.4.121

Where allowance is made for shareholder transfers, this should be in respect of the accrued bonus entitlement reflected in the retrospective reserve. This would include both annual bonuses already declared and accrued final bonus. However, shareholder transfers in respect of surplus yet to be credited to retrospective reserves should not be charged to those reserves until the corresponding surplus is credited.

31/12/2004

PRU 7.4.122

In calculating retrospective reserves, a firm must have regard to its regulatory duty to treat its customers fairly and must ensure that its approach is consistent with its Principles and Practices of Financial Management.

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PRU 7.4.123

In calculating retrospective reserves, a firm must ensure its treatment of past cash flows, and of any future cash flows, is consistent with those cash flows valued in its prospective calculation of the future policy related liabilities for that fund in accordance with the rules in PRU 7.4.136 G to PRU 7.4.189 G.

31/12/2004

PRU 7.4.124

An example of PRU 7.4.123 R concerns future shareholder transfers. A firm must make adequate provision for future shareholder transfers within the future policy related liabilities (see PRU 7.4.165 R). The basis of provisioning needs to be consistent with the amounts accrued within retrospective reserves and the amounts already transferred out of the with-profits fund.

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PRU 7.4.125

Another example of the application of PRU 7.4.123 R relates to the reference in PRU 7.4.119 R (8) to past permanent enhancements to (or deductions from) retrospective reserves made by firms. This item may include past miscellaneous surplus (or losses) which have been credited to (or debited from) retrospective reserves. Any other enhancements (or deductions) made on a temporary basis and any future surplus (or losses) that firms intend to credit to (or debit from) retrospective reserves should be included under the future policy related liabilities (see PRU 7.4.137 R).

31/12/2004

PRU 7.4.126

Firms characteristically use a range of calculation methods to determine retrospective reserves. A firm's definition and calculation of retrospective reserves will depend on a number of factors. These include: the firm's practice; its administration and accounting systems; the extent of its historical records; and the composition of its with-profits portfolio. The rules and guidance for the retrospective method are drawn up to be sufficiently flexible to accommodate the diversity of calculation methods used by firms, rather than to enforce any particular method of calculation of retrospective reserves. PRU 7.4.119 R simply sets minimum standards that all retrospective methods must meet.

31/12/2004

PRU 7.4.127

For the purposes of PRU 7.4.119 R (2) and PRU 7.4.128 R (2), the phrases 'charges made' or 'charges to be made' refer to circumstances where types of risk (such as mortality risk, longevity risk and investment risk) are met by the firm or with-profits fund in return for a charge deducted by the firm from the with-profits benefits reserve.

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Prospective method

PRU 7.4.128

In the prospective method of calculating a with-profits benefits reserve, a firm must take account of at least the following cash flows:

(1) future premiums;
(2) expenses to be incurred or charges to be made, including commissions;
(3) benefits payable (PRU 7.4.129 R);
(4) tax payable;
(5) any amounts to be received (or paid) under contracts of reinsurance or analogous non-reinsurance financing agreements, where relevant to with-profits insurance contracts being valued; and
(6) shareholder transfers.

31/12/2004

PRU 7.4.129

For the purposes of PRU 7.4.128 R (3), benefits payable include:

(1) all guaranteed benefits, including guaranteed amounts payable on death and maturity, guaranteed surrender values and paid-up values;
(2) vested, declared and allotted bonuses to which policyholders are entitled; and
(3) future annual and final bonuses at least equal to the levels required for the firm to fulfil its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.130

A firm must value the cash flows listed in PRU 7.4.128 R using best estimate assumptions of future experience, having regard to generally accepted actuarial practice and taking into account the firm's PPFM and its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.131

The prospective method sets the with-profits benefits reserve at the net present value of future cash flows listed in PRU 7.4.128 R.

31/12/2004

PRU 7.4.132

In contrast to PRU 7.3.10 R (4) and PRU 7.3.13 R relating to the methods and assumptions used to value the mathematical reserves, there is no requirement to value future cash flows using assumptions that include margins for adverse deviation. Also there are no detailed rules as to the future yields on assets, discount rates, premium levels, expenses, tax, mortality, morbidity, persistency and reinsurance. A firm should make its own assessment as to the amount of these future cash flows including bonuses and discretionary surrender or transfer values. A firm should make a realistic assessment of longevity risk and asset default risk (including default risk arising under contracts of reinsurance or analogous non-reinsurance financing agreements) within the best estimate assumptions of future experience required by PRU 7.4.130 R.

31/12/2004

PRU 7.4.133

In valuing the future cash flows listed in PRU 7.4.128 R, the firm should use a projection term which is long enough to capture all material cash flows arising from the contract or groups of contracts being valued. If the projection term does not extend to the term of the last policy, the firm should check that the shorter projection term does not significantly affect the results.

31/12/2004

PRU 7.4.134

Where a firm expects to pay additional benefits that are not included in the cash flows listed in PRU 7.4.128 R, it must make adequate provision for these benefits in calculating the future policy related liabilities in accordance with the rules in PRU 7.4.136 G to PRU 7.4.189 G.

31/12/2004

PRU 7.4.135

The prospective assessment of the with-profits benefits reserve will usually be on a deterministic basis. A firm will have to make further provision in the future policy-related liabilities for, for example, the costs of potential asset fluctuations or policy options.

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Overview of liabilities

PRU 7.4.136

PRU 7.4.137 R lists the future policy related liabilities for a with-profits fund that form part of a firm's realistic value of liabilities in PRU 7.4.40 R. Detailed rules and guidance relating to particular types of liability and asset are set out in PRU 7.4.139 R to PRU 7.4.168 G. These are followed by rules and guidance that deal with certain aspects of several liabilities (that is, liabilities relating to guarantees, options and smoothing):

(1) PRU 7.4.169 R to PRU 7.4.186 G refer to valuing the costs of guarantees, options and smoothing; and
(2) PRU 7.4.187 R to PRU 7.4.189 G refer to the treatment of surplus on guarantees, options and smoothing.

31/12/2004

PRU 7.4.137

The future policy related liabilities for a with-profits fund are equal to the sum of amounts, as they relate to that fund, in respect of (1) to (11) to the extent each is valued as a liability less the sum of amounts, as they relate to that fund, in respect of (1) to (11) to the extent each is valued as an asset:

(1) past miscellaneous surplus (or deficit) planned to be attributed to the with-profits benefits reserve (see PRU 7.4.139 R);
(2) planned enhancements to the with-profits benefits reserve (see PRU 7.4.141 R);
(3) planned deductions for the costs of guarantees, options and smoothing from the with-profits benefits reserve (see PRU 7.4.144 R);
(4) planned deductions for other costs deemed chargeable to the with-profits benefits reserve (see PRU 7.4.146 R);
(5) future costs of contractual guarantees (other than financial options) (see PRU 7.4.148 R);
(6) future costs of non-contractual commitments (see PRU 7.4.154 R);
(7) future costs of financial options (see PRU 7.4.156 G);
(8) future costs of smoothing (see PRU 7.4.158 R);
(9) financing costs (see PRU 7.4.162 R);
(10) any other further liabilities required for the firm to fulfil its regulatory duty to treat its customers fairly; and
(11) other long-term insurance liabilities (see PRU 7.4.165 R).

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PRU 7.4.138

Some of the elements of the calculation set out in PRU 7.4.137 R may have already been taken into consideration in the calculation of the with-profits benefits reserve, either under the retrospective method (see PRU 7.4.118 R onwards) or the prospective method (see PRU 7.4.128 R onwards). Where this is the case, the adjustments made under PRU 7.4.137 R should be such that no double-counting arises.

31/12/2004

Past miscellaneous surplus (or deficit) planned to be attributed to the with-profits benefits reserve

PRU 7.4.139

In calculating the future policy related liabilities for a with-profits fund, a firm must allow for past miscellaneous surplus (or deficit) which it intends to attribute to the with-profits benefits reserve for that fund but which has not yet been permanently credited to (or debited from) the with-profits benefits reserve for that fund.

31/12/2004

PRU 7.4.140

Past miscellaneous surplus (or deficit) already permanently credited to (or debited from) the with-profits benefits reserve will have been included in the calculation of the with-profits benefits reserve in accordance with PRU 7.4.119 R (8).

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Planned enhancements to the with-profits benefits reserve

PRU 7.4.141

In calculating the future policy related liabilities for a with-profits fund, a firm must make provision for any future planned enhancements to the with-profits benefits reserve for that fund that cannot be financed out of the resources of the with-profits benefits reserve and future premiums.

31/12/2004

PRU 7.4.142

For the purposes of PRU 7.4.141 R, planned enhancements to the with-profits benefits reserve will arise when a firm has a contractual obligation, or a non-contractual commitment (arising from its regulatory duty to treat customers fairly), to enhance claims on some classes of policy (perhaps in the form of specially enhanced future bonus rates). In such circumstances, the present value of the costs of paying out a target asset share that is more than the projected with-profits benefits reserve for those classes of policy for which this practice is applicable should be included in the amount of the future policy related liabilities. For example, a firm may have a non-contractual commitment (arising from its regulatory duty to treat customers fairly) to pay enhanced benefits but have discretion not to make such payments in adverse circumstances. Such planned enhancements should be provided for in the realistic balance sheet, but allowance should be made for management action in the calculation of the risk capital margin.

31/12/2004

PRU 7.4.143

The valuation of claims in excess of targeted asset shares in respect of guarantees, options and smoothing, including those arising under guaranteed annuity rates, should be carried out in accordance with PRU 7.4.169 R to PRU 7.4.186 G.

31/12/2004

Planned deductions for the costs of guarantees, options and smoothing from the with-profits benefits reserve

PRU 7.4.144

Where a firm expects to deduct future charges from the with-profits benefits reserve for a with-profits fund to cover the costs of guarantees, options or smoothing for that fund, the firm must take credit for these future charges in calculating the future policy related liabilities for that fund.

31/12/2004

PRU 7.4.145

In calculating future policy related liabilities for a with-profits fund, a firm should take credit under PRU 7.4.137 R (3) for the present value of the future "margins" available in respect of charges deducted to cover the costs of guarantees, options and smoothing. PRU 7.4.188 R requires firms that accumulate the charges made less costs incurred to provide for any surplus on the experience account as a realistic liability. Any such provision should be made under PRU 7.4.137 R (5), PRU 7.4.137 R (7) or PRU 7.4.137R (8) depending on the nature of the charges made, and has no effect on the amount calculated under PRU 7.4.144 R.

31/12/2004

Planned deductions for other costs deemed chargeable to the with-profits benefits reserve

PRU 7.4.146

Where a firm expects to deduct future charges (other than those valued in PRU 7.4.144 R) from the with-profits benefits reserve for a with-profits fund, the firm must take credit for these future charges in calculating the future policy-related liabilities for that fund.

31/12/2004

PRU 7.4.147

A firm should take credit for the present value of the other future "margins" available. The circumstances where such margins may arise include:

(1) where a firm is targeting claims at less than 100% of the with-profits benefits reserve, the amount of such shortfall; and
(2) where a firm expects to deduct any future charges (other than those for guarantees, options and smoothing) from the with-profits benefits reserve.

31/12/2004

Future costs of contractual guarantees (other than financial options)

PRU 7.4.148

A firm must make provision for the costs of paying excess claim amounts for a with-profits fund where the firm expects that the amount in (1) may be greater than the amount in (2), calculated as at the date of claim:

(1) the value of guarantees arising under a policy or group of policies in the fund; and
(2) the fund's with-profits benefits reserve allocated in respect of that policy or group of policies.

31/12/2004

PRU 7.4.149

For the purposes of PRU 7.4.148 R, the future costs of guarantees cannot be negative.

31/12/2004

PRU 7.4.150

In carrying out projections to calculate the cost of guarantees under PRU 7.4.137 R the opening liability should be set equal to the with-profits benefit reserve (see PRU 7.4.118 R), adjusted for miscellaneous surplus or deficits (see PRU 7.4.137 R (1)) and planned enhancements (see PRU 7.4.141 R).

31/12/2004

PRU 7.4.151

In projecting forward the with-profits benefits reserve, adjusted as in PRU 7.4.150 G, to the date of claim for the purposes of PRU 7.4.148 R, the firm should use market consistent assumptions for the expected future premium and investment income (including realised and unrealised gains or losses), expenses and claims, any charges to be deducted, tax and any other item of income or outgo. This projection should be carried out on the same basis as is described in PRU 7.4.130 R.

31/12/2004

PRU 7.4.152

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of guarantees, options and smoothing.

31/12/2004

PRU 7.4.153

Some examples of contractual guarantees are:

(1) for conventional with-profits insurance contracts, guaranteed sums assured and bonuses on death, maturity or retirement; and
(2) for accumulating with-profits policies, guarantees at a point in time or guaranteed minimum bonus rates.

31/12/2004

Future costs of non-contractual commitments

PRU 7.4.154

A firm must make provision for future costs in addition to those in PRU 7.4.148 R where the firm expects to pay further amounts to meet non-contractual commitments to customers or pay other benefits that need to be provided to fulfil a firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.155

Some examples of these non-contractual commitments are:

(1) statements by the firm regarding the ability of policies to cover defined amounts, such as the repayment of a mortgage;
(2) statements by the firm regarding regular withdrawals from a policy being without penalty;
(3) guaranteed annuity and cash option rates being provided beyond the strict interpretation of the policy; and
(4) the costs of any promises to customers or other benefits that need to be provided to fulfil a firm's regulatory duty to treat its customers fairly.

31/12/2004

Future costs of financial options

PRU 7.4.156

Financial options include guaranteed annuity and cash option rates.

31/12/2004

PRU 7.4.157

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of options.

31/12/2004

Future costs of smoothing

PRU 7.4.158

A firm must make provision for future smoothing costs of a with-profits fund where the firm expects that the claims paid on a policy or group of policies in the fund will vary from the greater of:

(1) the value of guarantees determined in PRU 7.4.148 R in respect of that policy or group of policies; and
(2) the fund's with-profits benefits reserve allocated in respect of that policy or group of policies which must be enhanced as described in PRU 7.4.141 R;
calculated as at the date of claim.

31/12/2004

PRU 7.4.159

For the purposes of PRU 7.4.158 R, smoothing costs are defined as the present value of the difference between projected claims and the projected with-profits benefit reserve after enhancements (PRU 7.4.141 R), other than payouts on guarantees (PRU 7.4.148 R).

31/12/2004

PRU 7.4.160

Subject to PRU 7.4.188 R, the future costs of smoothing can be negative.

31/12/2004

PRU 7.4.161

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of the future costs of smoothing.

31/12/2004

Financing costs

PRU 7.4.162

A firm must provide for future liabilities to repay financing costs of a with-profits fund where the firm expects to have to meet such liabilities and to the extent that these liabilities are not already provided for by amounts included in the fund's realistic current liabilities (PRU 7.4.190 R and PRU 7.4.191 R). The amount of the liabilities to repay financing costs must be assessed on a market-consistent basis.

31/12/2004

PRU 7.4.163

In PRU 7.4.162 R, financing costs refer to the future costs incurred by way of capital, interest and fees payable to the provider. A firm should make a realistic assessment of the requirement to repay such financing in its expected future circumstances (which may be worse than currently). Having taken account of its particular circumstances:

(1) where a firm has no liability to repay such financing, it should not include such repayment as a liability;
(2) where a firm has a reduced liability to repay such financing, it should include a reduced repayment as a liability.

31/12/2004

PRU 7.4.164

In PRU 7.4.162 R, financing includes reinsurance financing arrangements and analogous non-reinsurance financing arrangements, such as contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

31/12/2004

Other long-term insurance liabilities

PRU 7.4.165

A firm must provide for any other long-term insurance liabilities arising from or in connection with with-profits insurance contracts in a with-profits fund, to the extent that adequate provision has not been made in the with-profits benefits reserve or in any other part of the future policy related liabilities for that fund.

31/12/2004

PRU 7.4.166

Some examples of these other long-term insurance liabilities are:

(1) pension and other mis-selling reserves;
(2) provisions for tax; and
(3) provisions for future shareholder transfers.

31/12/2004

PRU 7.4.167

In determining the realistic liability for taxation firms should apply the general principles set out in PRU 7.4.105 R and the guidance given in PRU 7.4.107 G.

31/12/2004

PRU 7.4.168

PRU 7.4.105 R requires firms to provide for shareholder transfers out of the with-profits fund as a liability of the fund. The provision should be consistent with the methods and assumptions used in valuing the other realistic liabilities. So, for example, where the with-profits benefits reserve includes amounts that would be paid to policyholders through future bonuses, provision should also be made for future shareholder transfers associated with those bonuses.

31/12/2004

Valuing the costs of guarantees, options and smoothing

PRU 7.4.169

For the purposes of PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8), a firm must calculate the costs of any guarantees, options and smoothing using one or more of the following three methods:

(1) a stochastic approach using a market-consistent asset model (PRU 7.4.170 R);
(2) using the market costs of hedging the guarantee or option;
(3) a series of deterministic projections with attributed probabilities.

31/12/2004

PRU 7.4.170

The market-consistent asset model in PRU 7.4.169 R (1):

(1) means a model that delivers prices for assets and liabilities that can be directly verified from the market; and
(2) must be calibrated to deliver market-consistent prices for those assets that reflect the nature and term of the with-profits insurance liabilities of the with-profits fund.

31/12/2004

PRU 7.4.171

Deterministic approaches will not usually capture the time value of the option generated by a guarantee. In order to calculate this value properly, firms are expected either to use market option values where these are readily available or to undertake a stochastic approach using a market-consistent asset model.

31/12/2004

PRU 7.4.172

The FSA considers stochastic modelling to be preferable for material groups or classes of with-profits insurance contracts unless it can be shown that more simplistic or alternative methods are both appropriate and sufficiently robust.

31/12/2004

PRU 7.4.173

Where the guarantee or option is relatively simple in nature, is capable of being hedged, and has a value unlikely to be affected by management actions (PRU 7.4.185 R) (for example, a guaranteed annuity rate option) then the cost of the guarantee or option would be the market cost of hedging the guarantee. Where that is generally the case but, in respect of a minor part of a portfolio, no market exists for hedging the option generated by the guarantee, a firm should take the value of the nearest equivalent benefit or right for which a market exists and record how it has adjusted the valuation to reflect the original option. Where the market value of the hedge is used firms should also make provisions for the credit risk arising from the hedge, both that arising from exposure to a counterparty and that arising from credit risk in the underlying instrument. The extent to which the guarantee or option is capable of being hedged depends on a firm's assumptions regarding future investment mix, persistency, annuitant mortality and take-up rates. While the FSA recognises that the hedge may not be perfectly matched to the underlying guarantee or option, a firm should ensure that hedge is reasonably well matched having regard to the sensitivity of the guarantee or option to the firm's choice of key assumptions.

31/12/2004

PRU 7.4.174

Where a firm has large cohorts of guarantees and uses stochastic or deterministic approaches, a firm should have regard to whether the cost of the guarantees determined under those approaches bears a reasonable relationship to the market cost of hedging those guarantees (where it exists).

31/12/2004

PRU 7.4.175

In determining the costs of smoothing, a firm should consider:

(1) the consistency of its assumptions (including the exercise of management discretion over bonus rates); and
(2) where targeted payouts currently exceed retrospective reserves in respect of those claims, the assumptions used in reducing the excess, if applicable,

having regard to the firm's PPFM and its regulatory duty to treat its customers fairly.

31/12/2004

Stochastic approach

PRU 7.4.176

For the purposes of PRU 7.4.169 R (1), a stochastic approach would consist of an appropriate market-consistent asset model for projections of asset prices and yields (such as equity prices, fixed interest yields and property yields), together with a dynamic model incorporating the corresponding value of liabilities and the impact of any foreseeable actions to be taken by management. Under the stochastic approach, the cost of the guarantee, option or smoothing would be equal to the average of these stochastic projections.

31/12/2004

PRU 7.4.177

In performing the projections of assets and liabilities under the stochastic approach in PRU 7.4.169 R (1), a firm should have regard to the aspects in (1) and (2).

(1) The projection term should be long enough to capture all material cash flows arising from the contract or groups of contracts being valued. If the projection term does not extend to the term of the last policy, the firm should check that the shorter projection term does not significantly affect the results.
(2) The number of projections should be sufficient to ensure a reasonable degree of convergence in the results, including the determination of the result of the risk capital margin. The firm should test the sensitivity of the results to the number of projections.

31/12/2004

PRU 7.4.178

The FSA considers a holistic approach to stochastic modelling to be preferable so as to value all items of costs together rather than using separate methods for different items of the realistic value of liabilities. This approach requires the projection of all material cash flows arising under the contract or group of contracts for each stochastic projection, rather than only those arising from the guarantee or option within the contract. The advantages of this approach are that it ensures greater consistency in the valuation of different components of the contract and explicitly takes into account the underlying hedges or risk mitigation between components of the contract or group of contracts being valued. Where a firm can use a stochastic approach to value simultaneously all components of the contract or group of contracts, the firm should adopt this approach where practical and feasible.

31/12/2004

PRU 7.4.179

Where a stochastic approach is used, a firm should make and retain a record under PRU 7.4.17 R of the nature of the asset model and of the assumptions used (including the volatility of asset values and any assumed correlations between asset classes or between asset classes and economic indicators, such as inflation).

31/12/2004

PRU 7.4.180

In calibrating asset models for the purposes of PRU 7.4.170 R, a firm should have regard to the aspects in (1), (2) and (3).

(1) Few (if any) asset models can replicate all the observable market values for a wide range of asset classes. A firm should calibrate its asset models to reflect the nature and term of the fund's liabilities giving rise to significant guarantee and option costs.
(2) A firm will need to apply judgement to determine suitable estimates of those parameters which cannot be implied from observable market prices (for example, long-term volatility). A firm should make and retain a record under PRU 7.4.17 R of the choice of parameters and the reasons for their use.
(3) A firm should calibrate the model to the current risk-free yield curve. Risk-free yields should be determined after allowing for credit and all other risks arising. Firms may have regard to any guidance from the actuarial profession on the calculation of the risk-free yield but should not assume a higher yield than suggested by any such guidance.

31/12/2004

Deterministic approach

PRU 7.4.181

For the purposes of the deterministic approach in PRU 7.4.169 R (3), a firm must calculate a series of deterministic projections of the values of assets and corresponding liabilities, where each deterministic projection corresponds to a possible economic scenario or outcome.

31/12/2004

PRU 7.4.182

A firm should determine a range of scenarios or outcomes appropriate to both valuing the costs of the guarantee, option or smoothing and the underlying asset mix, together with the associated probability of occurrence. These probabilities of occurrence should be weighted towards adverse scenarios to reflect market pricing for risk. The costs of the guarantee, option or smoothing should be equal to the expected cost based on a series of deterministic projections of the values of assets and corresponding liabilities. In using a series of deterministic projections, a firm should consider whether its approach provides a suitably robust estimate of the costs of the guarantee, option or smoothing.

31/12/2004

PRU 7.4.183

In performing the projections of assets and liabilities under the deterministic approach in PRU 7.4.169 R (3), a firm should have regard to the aspects in (1) and (2).

(1) The projection term should be long enough to capture all material cash flows arising from the contract or group of contracts being valued. If the projection term does not extend to the term of the last contract, the firm should check that the shorter projection term does not significantly affect the results.
(2) The series of deterministic projections should be numerous enough to capture a wide range of possible outcomes and take into account the probability of each outcome's likelihood. The costs will be understated if only relatively benign or limited economic scenarios are considered.

31/12/2004

PRU 7.4.184

Where a series of deterministic projections is used, a firm should make and retain a record under PRU 7.4.17 R of the range of projections and how the probabilities attributed to each projection or outcome were determined (including the period of reference for any relevant data on past experience).

31/12/2004

Management and policyholder actions

PRU 7.4.185

In calculating the costs of any guarantees, options or smoothing, a firm:

(1) may reflect its prospective management actions (within the meaning of PRU 7.4.53 R); and
(2) must reflect a realistic assessment of the policyholder actions (within the meaning of PRU 7.4.59 R);

in its projections of the value of assets and liabilities.

31/12/2004

PRU 7.4.186

For the purposes of PRU 7.4.185 R, the related guidance in PRU 7.4.54 G to PRU 7.4.57 G (management actions) and in PRU 7.4.60 G (policyholder actions) applies.

31/12/2004

Treatment of surplus on guarantees, options and smoothing

PRU 7.4.187

PRU 7.4.188 R applies to firms calculating the costs of guarantees, options and smoothing to be included in the future policy-related liabilities in accordance with PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8).

31/12/2004

PRU 7.4.188

Where a firm accumulates past experience and deducts or is otherwise able to take credit for charges for guarantees or options or smoothing, the future costs of guarantees or options or smoothing (as appropriate) must not be less than the greater of:

(1) the prospective calculation of the future cost of guarantees (see PRU 7.4.148 R) or options (see PRU 7.4.156 G) or smoothing (see PRU 7.4.158 R) (as appropriate); and
(2) the sum of:

(a) the accumulated charges (after deduction of past costs) for guarantees or options or smoothing (as appropriate); and
(b) the prospective calculation of the future charges deducted for guarantees or options or smoothing (see PRU 7.4.144 R) (as appropriate).

31/12/2004

PRU 7.4.189

The extent to which the amount in PRU 7.4.188 R (2) exceeds the amount in PRU 7.4.188 R (1) will determine the surplus available to support actions that would be taken by the firm's management. The purpose of PRU 7.4.188 R is to ensure that any resulting surplus at the valuation date arising from the accumulation of charges less costs remains available to support foreseeable actions that would be taken by the firm's management. Any additional liability arising from PRU 7.4.188 R is added to the liabilities under PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8), but has no impact on the adjustment for planned deductions for the costs of guarantees, options and smoothing (PRU 7.4.137 R (3) and PRU 7.4.144 R).

31/12/2004

Realistic current liabilities

PRU 7.4.190

For the purposes of PRU 7.4.40 R (3), the realistic current liabilities of a with-profits fund are equal to the sum of the following amounts:

(1) the firm's best estimate provision for those liabilities for which prudent provision is made in regulatory current liabilities (see PRU 7.4.30 R); and
(2) to the extent that amounts have not been provided in (1), any tax and any other costs arising either in respect of excess admissible assets (within the meaning of PRU 7.4.36 R) or on the recognition of future shareholder transfers.

31/12/2004

PRU 7.4.191

For the purpose of assessing the best estimate provision to be made under PRU 7.4.190 R (1) in respect of a defined benefit occupational pension scheme, a firm must use either its defined benefit liability or its deficit reduction amount, consistent with the firm's election under PRU 1.3.5BR (2).

21/04/2005
Past version of PRU 7.4.191 before 21/04/2005

PRU 7.5

Equalisation provisions

31/12/2004

Application

PRU 7.5.1

PRU 7.5 applies to an insurer carrying on general insurance business unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

31/12/2004

PRU 7.5.2

The scope of PRU 7.5.11 R to PRU 7.5.37 G (non-credit equalisation provisions) is not restricted to firms subject to the relevant EC directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 7.5.3

The requirements of this section apply to a firm on a solo basis.

31/12/2004

Purpose

PRU 7.5.4

This section sets out rules and guidance on the calculation of the amount of the equalisation provisions that are required to be maintained by firms that carry on non-credit insurance business or credit insurance business.

31/12/2004

PRU 7.5.5

Credit or non-credit equalisation provisions form part of the technical provisions that a firm is required to establish under PRU 7.2.12 R (1). They help to smooth fluctuations in loss ratios in future years for business where claims in any future year may be subject to significant deviation from recent or average claims experience, or where trends in experience may be subject to change. Such volatile claims experience might arise in the case, for example, of insurance against losses caused by major catastrophes such as hurricanes or earthquakes.

31/12/2004

PRU 7.5.6

In general terms, PRU 7.5 sets out rules and guidance as to:

(1) the circumstances in which a firm is required to maintain equalisation provisions;
(2) the methods to be used in calculating the amount of each provision;
(3) the geographical location of the business relevant to certain calculations for different types of firm - this is summarised in the Table in PRU 7.5.7 G.

31/12/2004

PRU 7.5.7

Table: Scope of insurance business to be included in calculations

Type Of Firm

Credit Equalisation Provision

Non Credit Equalisation Provision

Threshold in PRU 7.5.44 R

Provision in PRU 7.5.43 R

Threshold in PRU 7.5.18 R (2) and provision in PRU 7.5.17 R

UK insurer

World-wide

Pure reinsurer with head office outside United Kingdom

PRU 7.5.39 R to PRU 7.5.47 G do not apply

Pure reinsurer with head office in United Kingdom

PRU 7.5.39 R to PRU 7.5.47 G do not apply

World-wide

Non-EEA direct insurers

EEA-deposit insurer

Swiss general insurer

UK-deposit insurer

All EEA

World-wide

All other non-EEA direct insurers

World-wide

31/12/2004

PRU 7.5.8

The First Non-Life Directive (as amended) requires the calculation of credit equalisation provisions. Non-credit equalisation provisions are a domestic United Kingdom requirement. For insurance regulatory purposes under EC Directives, credit equalisation provisions are classified as liabilities.

31/12/2004

PRU 7.5.9

However, firms are permitted to include equalisation provisions within their financial resources when demonstrating compliance with non-Directive capital requirements. Hence equalisation provisions are deducted from the available capital resources of a firm for the purpose of meeting its minimum capital requirement for general insurance business; but, in the calculation of a firm's enhanced capital requirement for general insurance business under PRU 2.3.11 R, its equalisation provisions (if any) are added back to its capital resources.

31/12/2004

PRU 7.5.10

Under International Accounting Standards (IAS), which will apply to the financial statements of some insurers from 2005, there will be no requirement to treat equalisation provisions as liabilities in insurers' published financial statements. However, they will continue to be treated as liabilities for the purposes of demonstrating compliance with Directive capital requirements.

31/12/2004

Firms carrying on non-credit insurance business

PRU 7.5.11

(1) PRU 7.5.11 R to PRU 7.5.37 G apply to any firm, other than an assessable mutual, which carries on the business of effecting or carrying out general insurance contracts falling within any description in column 2 in Table PRU 7.5.12 R ("non-credit insurance business").
(2) A firm falling within (1) must classify all of its non-credit insurance business into separate insurance business groupings, as specified in Table PRU 7.5.12 R.

31/12/2004

PRU 7.5.12

Table : Groupings of non-credit insurance business

Insurance Business Grouping

General Insurance Contracts

Contracts of insurance which fall within general insurance business classes 4, 8 or 9, other than:

(a) contracts of insurance under non-proportional reinsurance treaties; and

(b) contracts of insurance against nuclear risks.

Contracts of insurance which fall within general insurance business class 16(a) , other than:

(a) contracts of insurance under non-proportional reinsurance treaties; and

(b) contracts of insurance against nuclear risks.

Contracts of insurance which fall within general insurance business classes 5, 6, 11 or 12, other than:

(a) contracts of insurance against nuclear risks; and

(b) reinsurance contracts corresponding to contracts in (a).

Contracts of insurance against nuclear risks.

Contracts of insurance under non-proportional reinsurance treaties and which fall within general insurance business classes 4, 8, 9 or 16(a) other than contracts of insurance against nuclear risks.

31/12/2004

PRU 7.5.13

For the purposes of PRU 7.5.11 R to PRU 7.5.37 G, a firm with its head office in the United Kingdom must take account of non-credit insurance business carried on by it world-wide.

31/12/2004

PRU 7.5.14

For the purposes of PRU 7.5.11 R to PRU 7.5.37 G, a firm with its head office outside the United Kingdom need only take account of non-credit insurance business carried on by it from a branch in the United Kingdom.

31/12/2004

PRU 7.5.15

The insurers affected by PRU 7.5.11 R include pure reinsurers, UK-deposit insurers, EEA-deposit insurer, and Swiss general insurers.

31/12/2004

PRU 7.5.16

For insurers (including pure reinsurers) with a head office in the United Kingdom, the calculations must be made in respect of world-wide business.

31/12/2004

Requirement to maintain non-credit equalisation provision

PRU 7.5.17

In respect of each financial year, a firm must, unless PRU 7.5.18 R applies:

(1) calculate the amount of its non-credit equalisation provision as at the end of that year in accordance with PRU 7.5.20 R; and
(2) maintain a non-credit equalisation provision calculated in accordance with PRU 7.5.20 R for the following financial year.

31/12/2004

PRU 7.5.18

(1) PRU 7.5.17 R does not apply to any firm in respect of any financial year if, as at the end of that year:

(a) no non-credit equalisation provision has been brought forward from the preceding financial year; and
(b) the amount of the annualised net written premiums for all the non-credit insurance business carried on by it in the financial year is less than the threshold amount.

(2) The threshold amount in respect of any financial year is the higher of:

(a) 1,500,000 Euro; and
(b) 4% of net written premiums in that financial year in respect of all its general insurance business, if this amount is less than 2,500,000 Euro.

31/12/2004

PRU 7.5.19

For non-EEA insurers, the calculation of the threshold amount in PRU 7.5.18 R (2) is limited by PRU 7.5.14 R to the business of the firm carried on in the United Kingdom. Such a firm may do little UK non-credit insurance business, and so would not be required to set up a non-credit equalisation provision under PRU 7.5, but may do significant business outside the United Kingdom characterised by high-impact, low-frequency claims. Such a firm is required by PRU 7.6.41 R to hold adequate world-wide financial resources to avoid internal-contagion strain on the branch in the United Kingdom. In determining the adequacy of its financial resources, the firm should undertake stress and scenario testing of its underwriting and other risks as set out in PRU 1.2.

31/12/2004

Calculating the amount of the provision

PRU 7.5.20

(1) Unless PRU 7.5.22 R applies, the amount of a firm's non-credit equalisation provision as at the end of a financial year is the higher of:

(a) zero; and
(b) whichever is the lower of:

(i) the aggregate of the amounts of the maximum provision for each insurance business grouping as at the end of that financial year; and
(ii) the sum of A and B.

(2) For the purposes of (1)(b)(ii):

(a) A is the amount of the non-credit equalisation provision, if any, brought forward from the financial year immediately preceding that in respect of which the calculation is being performed; and
(b) B is:

(i) the aggregate of the amounts of the provisional transfers-in for each insurance business grouping; minus
(ii) the aggregate of the amounts of the provisional transfers-out for each insurance business grouping.

(3) For any insurance business grouping:

(a) the amount of the maximum provision in (1)(b)(i) is to be determined in accordance with PRU 7.5.24 R;
(b) the amount of the provisional transfers-in in (2)(b)(i) is to be determined in accordance with PRU 7.5.26 R; and
(c) the amount of the provisional transfers-out in (2)(b)(ii) is to be determined in accordance with PRU 7.5.29 R.

31/12/2004

PRU 7.5.21

If provisional transfers-out are in excess of provisional transfers-in, the non-credit equalisation provision as calculated in accordance with PRU 7.5.20 R in respect of a particular financial year may be less than that calculated for the preceding financial year although, by virtue of PRU 7.5.20 R (1)(a), it cannot be negative.

31/12/2004

PRU 7.5.22

(1) The amount of a firm's non-credit equalisation provision as at the end of a financial year is zero if:

(a) as at the end of that year, the firm meets either of the conditions specified in (2) and (3); and
(b) the annualised net written premiums for all the non-credit insurance business carried on by the firm in that year are less than the threshold amount.

(2) The first condition is that the firm carried on non-credit insurance business in the first financial year of the relevant period and, for each of any two or more financial years of that period, the annualised net written premiums for business of that description were less than the threshold amount.
(3) The second condition is that the firm did not carry on non-credit insurance business in the first financial year of the relevant period and the average of the annualised net written premiums for business of that description carried on by the firm in each financial year of the relevant period was less than the threshold amount.
(4) For the purposes of this rule:

(a) the threshold amount is the amount determined in accordance with PRU 7.5.18 R (2): and
(b) the relevant period is the period of four financial years ending immediately before the beginning of the financial year in (1).

31/12/2004

PRU 7.5.23

If PRU 7.5.22 R applies, a firm may need to make sufficient transfers from its non-credit equalisation provision to bring the non-credit equalisation provision for that financial year to zero.

31/12/2004

The calculation: the maximum provision

PRU 7.5.24

(1) For the purposes of the calculation required by PRU 7.5.20 R, the amount of the maximum provision for any insurance business grouping is to be determined in accordance with (2) to (5).
(2) Unless (4) applies, the amount of the maximum provision for the grouping, as at the end of a financial year, is the amount determined by multiplying X and Y.
(3) For the purposes of (2):

(a) X is the percentage specified in Table PRU 7.5.25 R in relation to the grouping; and
(b) Y is the average of the amount of the annualised net written premiums for non-credit insurance business in the grouping carried on by the firm in each financial year of the relevant period.

(4) Where Y is a negative amount, the maximum provision for that insurance business grouping is zero.
(5) For the purposes of (3)(b), the relevant period is the five-year period comprising:

(a) the financial year in (2); and
(b) the previous four financial years.

31/12/2004

PRU 7.5.25

Table : Calculation of maximum provision for any insurance business grouping

Insurance Business Grouping

Percentage of average annualised net written premiums

600

31/12/2004

The calculation: provisional transfers-in

PRU 7.5.26

(1) For the purposes of the calculation required by PRU 7.5.20 R, the amount of the provisional transfers-in for any insurance business grouping is to be determined in accordance with (2).
(2) The amount of the provisional transfers-in for the grouping, as at the end of a financial year, is the amount determined by multiplying X and Y.
(3) For the purposes of (2):

(a) X is the percentage specified in Table PRU 7.5.27 R in relation to the grouping; and
(b) Y is the amount of the net written premiums for non-credit insurance business in the grouping that was carried on by the firm in the financial year in (2), including adjustments in respect of previous financial years.

31/12/2004

PRU 7.5.27

Table : Provisional transfers-in for any insurance business grouping

Insurance Business Grouping

Percentage of net written premiums

31/12/2004

PRU 7.5.28

Since each insurance business grouping should be assessed individually, negative net written premiums in relation to any insurance business grouping should be transferred in to the non-credit equalisation provision.

31/12/2004

The calculation: provisional transfers-out

PRU 7.5.29

(1) For the purposes of the calculation required by PRU 7.5.20 R, the amount of the provisional transfers-out for any insurance business grouping is to be determined in accordance with (2).
(2) The amount of the provisional transfers-out for the grouping, as at the end of a financial year, is the lower of:

(a) the amount of the maximum provision for the grouping under PRU 7.5.24 R for that financial year; and
(b) the abnormal loss for the grouping under PRU 7.5.30 R for that financial year.

31/12/2004

PRU 7.5.30

For each insurance business grouping, the abnormal loss as at the end of a financial year in relation to which an equalisation provision is calculated is:

(1) (for business within the insurance business grouping accounted for on an accident year basis) the amount, if any, by which the amount of net claims incurred exceeds the greater of:

(a) zero; and
(b) the percentage of net earned premiums in that financial year specified in the Table in PRU 7.5.31 R; or

(2) (for business within the insurance business grouping accounted for on an underwriting year basis) the amount, if any, by which the amount of net claims paid (plus adjustment for change in net technical provisions, other than any change in provisions for claims handling expenses or equalisation) exceeds the greater of:

(a) zero; and
(b) the percentage of net written premiums in that financial year specified in the Table in PRU 7.5.31 R.

31/12/2004

PRU 7.5.31

Table : Abnormal loss for any insurance business grouping

Insurance business grouping

Percentage of net written premiums

72.5

100

31/12/2004

Transfers of business from the firm

PRU 7.5.32

(1) This rule applies to modify the application of PRU 7.5.24 R and PRU 7.5.26 R in any case where a firm has transferred to another undertaking any rights and obligations under general insurance contracts falling within any insurance business grouping.
(2) As at the end of the financial year in which the transfer takes place, net written premiums in respect of the transferred contracts in any grouping must be deducted from total net written premiums for that grouping before calculating the maximum provision under PRU 7.5.24 R or provisional transfers-in under PRU 7.5.26 R.

31/12/2004

PRU 7.5.33

If all the rights and obligations of a firm in relation to non-credit insurance business in any insurance business grouping have been transferred, the maximum provision for the grouping under PRU 7.5.24 R is zero.

31/12/2004

Transfers of business to the firm

PRU 7.5.34

(1) This rule applies to modify the application of PRU 7.5.24 R, PRU 7.5.26 R and PRU 7.5.29 R in any case where another undertaking has transferred to a firm any rights and obligations under general insurance contracts falling within any insurance business grouping.
(2) As at the end of the financial year in which the transfer takes place a sum equal to that part of the consideration for the transfer that relates to business in an insurance business grouping must be:

(a) excluded from net premiums (written or earned) before performing the calculations required by PRU 7.5.24 R (maximum provision) and PRU 7.5.26 R (provisional transfers in);
(b) included in net premiums (written or earned) before performing the calculation required by PRU 7.5.30 R (abnormal loss); and
(c) excluded from net claims (paid or incurred) before performing the calculation required by PRU 7.5.30 R (abnormal loss).

31/12/2004

PRU 7.5.35

For the purposes of PRU 7.5.34 R, the consideration payable should be apportioned between insurance business groupings according to the groupings within which the general insurance contracts which are the subject of the acquisition fall. In appropriate cases, apportionment may reflect the split of liabilities acquired, including unearned premium.

31/12/2004

PRU 7.5.36

Where business is accounted for on an accounting year basis, in any year following the transfer, net earned premiums must include an appropriate amount in respect of the transfer.

31/12/2004

PRU 7.5.37

PRU 7.5.32 R to PRU 7.5.34 R apply to transfers by way of transfer under Part VII of the Act and by novation.

31/12/2004

Firms carrying on credit insurance business

PRU 7.5.38

PRU 7.5.39 R to PRU 7.5.47 G apply to:

(1) any UK insurer; and
(2) any non-EEA direct insurer;

which carries on the business of effecting or carrying out general insurance contracts falling within general insurance business class 14 (which business, excluding contracts of reinsurance, is referred to in PRU 7.5 as "credit insurance business").

31/12/2004

PRU 7.5.39

For the purposes of PRU 7.5.43 R, a UK insurer must take account of the credit insurance business carried on by it world-wide.

31/12/2004

PRU 7.5.40

(1) For the purposes of PRU 7.5.43 R:

(a) a Swiss general insurer or an EEA-deposit insurer must take account of the credit insurance business carried on by it in the United Kingdom; and
(b) a UK-deposit insurer must take account of the credit insurance business carried on by it world-wide.

(2) For the purposes of PRU 7.5.44 R:

(a) a UK-deposit insurer need only take account of the credit insurance business carried on by it in all EEA States, taken together; and
(b) any other description of non-EEA direct insurer (including an EEA-deposit insurer and a Swiss general insurer) need only take account of the credit insurance business carried on by it in the United Kingdom.

31/12/2004

PRU 7.5.41

For UK insurers the calculations must be made in respect of world-wide business.

31/12/2004

PRU 7.5.42

The requirements of PRU 7.5.39 R and PRU 7.5.40 R are summarised in the table in PRU 7.5.7 G.

31/12/2004

Requirement to maintain credit equalisation provision

PRU 7.5.43

In respect of each financial year, a UK insurer or a non-EEA direct insurer must, unless PRU 7.5.44 R applies:

(1) calculate the amount of its credit equalisation provision as at the end of that year in accordance with PRU 7.5.45 R; and
(2) maintain a credit equalisation provision calculated in accordance with PRU 7.5.45 R for the following financial year.

31/12/2004

PRU 7.5.44

PRU 7.5.43 R does not apply to any UK insurer or a non-EEA direct insurer in respect of any financial year if, as at the end of that year, the annualised net written premiums for its credit insurance business are less than 4% of annualised net written premiums in that financial year in respect of all its general insurance business, if this amount is less than 2,500,000 Euro.

31/12/2004

Calculating the amount of the provision

PRU 7.5.45

(1) The amount of a UK insurer's, or a non-EEA direct insurer's, credit equalisation provision as at the end of a financial year ("financial year A") is the higher of:

(a) zero; and
(b) whichever is the lower of:

(i) 150% of the highest amount of net written premiums for credit insurance business carried on by the firm in financial year A or in any of the previous four financial years; and
(ii) the amount of the credit equalisation provision brought forward from the preceding financial year, after making either of the adjustments in (2).

(2) The adjustments are:

(a) the deduction of the amount of any technical deficit arising in financial year A; or
(b) the addition of the lower of:

(i) 75% of the amount of any technical surplus arising in financial year A; and
(ii) 12% of the amount of the net written premiums for credit insurance business carried on by the firm in financial year A.

(3) For the purposes of (2) the amount of technical deficit or technical surplus is to be determined in accordance with PRU 7.5.46 R.

31/12/2004

PRU 7.5.46

For the purposes of the adjustments in PRU 7.5.45 R (2), technical surplus (or technical deficit) in respect of credit insurance business is the amount by which the aggregate of net earned premiums and other technical income exceeds (or falls short of) the sum of net claims incurred, claims management costs and any technical charges.

31/12/2004

PRU 7.5.47

The calculation of technical surplus or technical deficit should be made before tax and before any transfer to or from the credit equalisation provision. Investment income should not be included in these calculations.

31/12/2004

Euro conversion

PRU 7.5.48

For the purposes of PRU 7.5, the exchange rate from the Euro to the pound sterling for each year beginning on 31 December is the rate applicable on the last day of the preceding October for which the exchange rates for the currencies of all the European Union member states were published in the Official Journal of the European Union.

31/12/2004

PRU 7.6

Internal-contagion risk

31/12/2004

Application

PRU 7.6.1

PRU 7.6 applies to an insurer.

31/12/2004

PRU 7.6.2

PRU 7.6 does not apply, to the extent stated, to any insurer in (1) to (4):

(1) none of the provisions apply to non-directive friendly societies;
(2) none of the provisions, apart from PRU 7.6.33 R (payment of financial penalties) apply to firms which qualify for authorisation under Schedule 3 or 4 of the Act;
(3) PRU 7.6.33 R (payment of financial penalties) does not apply to mutuals;
(4) PRU 7.6.41 R to PRU 7.6.57 R (UK branches of certain non-EEA insurers) do not apply to:

(a) UK insurers; or
(b) non-EEA insurers which are pure reinsurers; or
(c) EEA-deposit insurers; or
(d) Swiss general insurers.

31/12/2004

PRU 7.6.3

The scope of application of PRU 7.6 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 7.6.4

In its application to a firm with its head office in the United Kingdom, this section applies to the whole of the firm's business carried on world-wide.

31/12/2004

PRU 7.6.5

In the application of this section to activities carried on by a non-EEA insurer:

(1) PRU 7.6.13 R to PRU 7.6.15 G and PRU 7.6.41 R apply in relation to the whole of its business carried on world-wide;
(2) all other provisions of this section apply only in relation to:

(a) in the case of any UK-deposit insurer, activities carried on from branches in any EEA State; and
(b) in any other case, activities carried on from a branch in the United Kingdom.

31/12/2004

PRU 7.6.6

The adequacy of a firm's financial resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

31/12/2004

PRU 7.6.7

The requirements of this section apply to a firm on a solo basis.

31/12/2004

Purpose

PRU 7.6.8

This section sets out requirements for a firm relating to 'internal-contagion risk'. This is the risk that losses or liabilities from one activity might deplete or divert financial resources held to meet liabilities from another activity. It arises where the two activities are carried on within the same firm. It may also arise from the combination of activities within the same group, but this aspect of internal-contagion risk falls outside the scope of this section. Requirements relevant to group contagion risk are set out in PRU 8.

31/12/2004

PRU 7.6.9

Internal-contagion risk includes in particular the risk that arises where a firm carries on:

(1) both insurance and non-insurance activities; or
(2) two or more different types of insurance activity; or
(3) insurance activities from offices or branches located in both the United Kingdom and overseas.

31/12/2004

PRU 7.6.10

This section requires firms to limit non-insurance activities to those that directly arise from their insurance business, e.g. investing assets, employing insurance staff etc. It also requires that an adequate provision be established for non-insurance liabilities.

31/12/2004

PRU 7.6.11

This section also sets out requirements for the separation of different types of insurance activity. However, in most circumstances the combination of different types of insurance activity within the same firm is a source of strength. Adequate pooling and diversification of insurance risk is fundamental to sound business practice. The requirements, therefore, only apply in two specific cases where without adequate protection the combination might operate to the detriment of policyholders. They apply where a firm carries on both:

(1) general insurance business and long-term insurance business;
(2) linked and non-linked insurance business.

31/12/2004

PRU 7.6.12

Finally, the section sets out requirements to protect policyholders of branches of non-EEA firms where these are supervised by the FSA. These apply only to a non-EEA firm that has established a branch in the United Kingdom.

31/12/2004

Restriction of business to insurance

PRU 7.6.13

(1) A firm must not carry on any commercial business other than insurance business and activities directly arising from that business.
(2) (1) does not prevent a friendly society which was on 15 March 1979 carrying on long-term insurance business from continuing to carry on savings business.

31/12/2004

Financial limitation of non-insurance activities

PRU 7.6.14

A firm must limit, manage and control its non-insurance activities so that there is no significant risk arising from those activities that it may be unable to meet its liabilities as they fall due.

31/12/2004

PRU 7.6.15

For the purpose of PRU 7.6.14 R a firm should consider how the financial impact of non-insurance activities might diverge from expectations. However, it need only take into account unexpected variations in amount and timing in so far as they are reasonably possible and may take into account effective mitigating factors.

31/12/2004

Requirements: long-term insurance business

PRU 7.6.16

PRU 7.6.18 R, PRU 7.6.21 R, PRU 7.6.30 R and PRU 7.6.31 R require a firm to identify the assets attributable to the receipts of the long-term insurance business, called long-term insurance assets, and only to apply those assets for the purpose of that business. This has the effect of prohibiting a composite firm from using long-term insurance assets to meet general insurance liabilities. It also keeps long-term insurance assets separate from shareholder funds.

31/12/2004

Permissions not to include both types of insurance

PRU 7.6.17

Under section 31 of the Act, a firm may not carry on a regulated activity unless it has permission to do so (or is exempt in relation to the particular activity). Both general insurance business and long-term insurance business are regulated activities and permission will extend to the effecting or carrying out of one or more particular classes of contracts of insurance. A firm's permission can be varied so as to add other classes. It is FSA policy, in compliance with EC directives on insurance, not to grant or vary permission if that would allow a firm to engage in both general insurance business and long-term insurance business. This does not apply where a firm's permission is restricted to reinsurance. It also does not apply where a firm's permission extends to effecting or carrying out life and annuity contracts of insurance. This will automatically include permission to effect or carry out accident contracts of insurance or sickness contracts of insurance on an ancillary or supplementary basis (see article 2(1) of the Consolidated Life Directive).

31/12/2004

Separately identify and maintain long term insurance assets

PRU 7.6.18

A firm carrying on long-term insurance business must identify the assets relating to its long-term insurance business which it is required to hold by virtue of PRU 7.2.20 R and PRU 7.2.21 R .

31/12/2004

PRU 7.6.19

PRU 7.2.16 R requires a firm to establish adequate technical provisions for its long-term insurance contracts. PRU 7.2.20 R requires a firm to hold admissible assets of a value at least equal to the amount of the technical provisions. PRU 7.2.21 R ensures that a composite firm identifies separate long-term insurance assets with a value at least equal to the technical provisions for long-term insurance business as well as holding other assets of a value at least equal to the amount of its technical provisions for general insurance business. The overall impact of these provisions in PRU 7.2, and of PRU 7.6.18 R, is that any firm writing long-term insurance business must identify separately its long-term insurance assets and ensure that their value is at least equal to the amount of its long-term insurance business technical provisions.

31/12/2004

PRU 7.6.20

PRU 7.6.18 R does not prohibit a firm from identifying other assets as being available to meet the liabilities of its long-term insurance business. It may transfer such other assets to a long-term insurance fund (see PRU 7.6.21 R and PRU 7.6.22 R ) and the transfer will take effect when it is recorded in the firm's accounting records (see PRU 7.6.23 R). After the transfer takes effect, a firm may not transfer the assets out of a long-term insurance fund except where they represent an established surplus (see PRU 7.6.27 R).

31/12/2004

PRU 7.6.21

(1) A firm's long-term insurance assets are the items in (2), adjusted to take account of:

(a) outgo in respect of the firm's long-term insurance business; and
(b) any transfers made in accordance with PRU 7.6.27 R.

(2) The items are:

(a) the assets identified under PRU 7.6.18 R (including assets into which those assets have been converted);
(b) any other assets identified by the firm as being available to cover its long-term insurance liabilities;
(c) premiums and other receivables in respect of long-term insurance contracts;
(d) other receipts of the long-term insurance business; and
(e) all income and capital receipts in respect of the items in (2).

31/12/2004

PRU 7.6.22

(1) Unless (2) applies, all the long-term insurance assets of the firm constitute its long-term insurance fund.
(2) Where a firm identifies particular long-term insurance assets in connection with different parts of its long-term insurance business, the assets identified in relation to each such part constitute separate long-term insurance funds of the firm.

31/12/2004

PRU 7.6.23

A firm must maintain a separate accounting record in respect of each of its long-term insurance funds (including any with-profits fund).

31/12/2004

PRU 7.6.24

Firms must ensure that long-term insurance assets are separately identified and allocated to a long-term insurance fund at all times. Assets in external accounts, for example at banks, custodians, or brokers should be segregated in the firm's books and records into separate accounts for long-term insurance business and general insurance business. Where a firm has more than one long-term insurance fund, a separate accounting record must be maintained for each fund. Accounting records should clearly document the allocation.

31/12/2004

PRU 7.6.25

Where the surplus arising from business is shared between policyholders and shareholders in different ways for different blocks of business, it may be necessary to maintain a separate fund to ensure that policyholders are, and will be, treated fairly. For example, if a proprietary company writes some business on a with-profits basis, this should be written in a with-profits fund separate from any business where the surplus arising from that business is wholly owned by shareholders.

31/12/2004

PRU 7.6.26

Where a firm merges separate funds for different types of business, it will need to ensure that the merger will not result in policyholders being treated unfairly. When considering merging the funds, the firm should consider the impact on its PPFM (see COB 6.10) and on its obligations to notify the FSA (see SUP 15.3). In particular, a firm would need to consider how any inherited estate would be managed and how the fund would be run in future, such that policyholders are treated fairly.

31/12/2004

PRU 7.6.27

A firm may not transfer assets out of a long-term insurance fund unless:

(1) the assets represent an established surplus; and
(2) no more than three months have passed since the determination of that surplus.

31/12/2004

PRU 7.6.28

As a result of PRU 7.6.27 R (2), an actuarial investigation undertaken to determine an established surplus remains in-date for three months from the date as at which the determination of the surplus was made. However, even where the investigation is still in-date, the firm should not make the transfer unless there is sufficient surplus at the time of the transfer to allow it to be made without breach of PRU 7.2.20 R or PRU 7.2.21 R.

31/12/2004

PRU 7.6.29

PRU 7.2.27 R and PRU 7.2.28 R provide further constraints on the transfer of assets out of a with-profits fund. PRU 7.2.27 R requires a firm to have admissible assets in each of its with-profits funds to cover the technical provisions relating to all the business in that fund. PRU 7.2.28 R requires a realistic basis life firm to ensure that the realistic value of assets for each of its with-profits funds is at least equal to the realistic value of liabilities of that fund.

31/12/2004

Exclusive use of long-term insurance assets

PRU 7.6.30

(1) A firm must apply a long-term insurance asset only for the purposes of its long-term insurance business.
(2) For the purpose of (1), applying an asset includes coming under any obligation (even if only contingently) to apply that asset.

31/12/2004

PRU 7.6.31

A firm must not agree to, or allow, any mortgage or charge on its long-term insurance assets other than in respect of a long-term insurance liability.

31/12/2004

PRU 7.6.32

The purposes of the long-term insurance business include the payment of claims, expenses and liabilities arising from that business, the acquisition of lawful access to fixed assets to be used in that business and the investment of assets. The payment of liabilities may include repaying a loan but only where that loan was incurred for the purpose of the long-term insurance business. The purchase or investment of assets may include an exchange at fair market value of assets (including money) between the long-term insurance fund and other assets of the firm.

31/12/2004

Payment of financial penalties

PRU 7.6.33

If the FSA imposes a financial penalty on a long-term insurer, the firm must not pay that financial penalty from a long-term insurance fund.

31/12/2004

PRU 7.6.34

PRU 7.6.2 R states that this provision applies to all firms, except mutuals, and includes firms qualifying for authorisation under Schedule 3 or 4 to the Act.

31/12/2004

Requirements: property-linked funds

PRU 7.6.35

PRU 4.2.57 R requires a firm to cover, as closely as possible, its property-linked liabilities by the property to which those liabilities are linked. In order to comply with this rule, a firm should identify the assets it holds to cover property-linked liabilities and should not apply those assets (as long as they are needed to cover the property-linked liabilities) for any purpose other than to meet those liabilities.

31/12/2004

PRU 7.6.36

A firm must select, allocate and manage the assets to which its property-linked liabilities are linked taking into account:

(1) the firm's contractual obligations to holders of property-linked policies; and
(2) its regulatory duty to treat customers fairly, including in the way it makes discretionary decisions as to how it selects, allocates and manages assets.

31/12/2004

PRU 7.6.37

Property-linked liabilities may be linked either to specified assets (with no contractual discretion given to the firm as to the choice of assets) or to assets of a specified kind where the selection of the actual assets is left to the firm.

31/12/2004

Requirements: UK branches of certain non-EEA firms

PRU 7.6.38

The purpose of the rules and guidance set out in PRU 7.6.38 G to PRU 7.6.57 R is to protect against the risk that the financial resources required in respect of the activities of the United Kingdom (or EEA) branch(es) might be depleted by the other activities of the non-EEA direct insurer.

31/12/2004

PRU 7.6.39

By virtue of PRU 7.6.2 R (4), the rules in PRU 7.6.41 R to PRU 7.6.57 R apply to non-EEA direct insurers except for Swiss general insurers and EEA-deposit insurers. Responsibility for determining the adequacy of the world-wide financial resources of Swiss general insurers or EEA-deposit insurers rests exclusively with the Swiss authorities or the authorities in the EEA state (other than the United Kingdom) in which the deposit was made.

31/12/2004

PRU 7.6.40

(1) PRU 7.6.41 R requires a non-EEA direct insurer to hold adequate world-wide resources to meet the needs of the world-wide business without the need to rely on UK or EEA branch assets other than to meet branch liabilities.
(2) PRU 7.6.42 R to PRU 7.6.47 R require non-EEA direct insurers to calculate a local MCR and to hold assets representing that requirement in the EEA or the United Kingdom.
(3) PRU 7.6.48 R to PRU 7.6.52 R require non-EEA direct insurers to hold a minimum level of assets in the United Kingdom or EEA.
(4) PRU 7.6.54 R requires the deposit of a minimum level of assets in the United Kingdom.
(5) PRU 7.6.56 R and PRU 7.6.57 R require non-EEA direct insurers to keep adequate accounting records in the United Kingdom.

31/12/2004

Worldwide financial resources

PRU 7.6.41

(1) A non-EEA direct insurer must maintain adequate worldwide financial resources, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.
(2) For the purpose of (1):

(a) a UK-deposit insurer must not rely upon the assets held under PRU 7.2.20 R as available to meet liabilities other than those arising from the activities of its branches in EEA States;
(b) other non-EEA direct insurers to whom (1) applies must not rely upon the assets held under PRU 7.2.20 R as available to meet liabilities other than those arising from the activities of any UK branch.

31/12/2004

UK or EEA MCR to be covered by admissible assets

PRU 7.6.42

A non-EEA direct insurer must:

(1) calculate a UK or EEA MCR in accordance with PRU 7.6.44 R to PRU 7.6.47 R; and
(2) hold admissible assets (in addition to those required under PRU 7.2.20 R) to represent its UK or EEA MCR calculated under (1).

31/12/2004

PRU 7.6.43

The assets held under PRU 7.6.42 R (2) must be identified and valued as if the non-EEA direct insurer was a firm with its head office in the United Kingdom.

31/12/2004

PRU 7.6.44

For the purposes of PRU 7.6.42 R, a non-EEA direct insurer (except a UK-deposit insurer) must calculate a UK MCR:

(1) for long-term insurance business, in accordance with PRU 7.2.81 R to PRU 7.2.91 R but only in relation to business carried on by the firm in the United Kingdom;
(2) for general insurance business, in accordance with PRU 7.2.45 R to PRU 7.2.72 R but only in relation to business carried on by the firm in the United Kingdom.

31/12/2004

PRU 7.6.45

For a composite firm, the UK MCR is the sum of the amounts arrived at under PRU 7.6.44 R (1) and PRU 7.6.44 R (2).

31/12/2004

PRU 7.6.46

For the purposes of PRU 7.6.42 R, a UK-deposit insurer must calculate an EEA MCR:

(1) for long-term insurance business, in accordance with PRU 7.2.81 R to PRU 7.2.91 R but only in relation to business carried on by the firm in all EEA States, taken together;
(2) for general insurance business, in accordance with PRU 7.2.45 R to PRU 7.2.72 R but only in relation to business carried on by the firm in all EEA States, taken together.

31/12/2004

PRU 7.6.47

For a composite firm, the EEA MCR is the sum of the amounts arrived at under PRU 7.6.46 R (1) and PRU 7.6.46 R (2).

31/12/2004

Localisation of assets

PRU 7.6.48

A non-EEA direct insurer (except a UK-deposit insurer) must hold admissible assets, which are required to cover its technical provisions in accordance with PRU 7.2.20 R and to represent its UK MCR in accordance with PRU 7.6.44 R:

(1) (where the assets cover the technical provisions and the guarantee fund) in the United Kingdom;
(2) (where the assets represent the amount of the UK MCR in excess of the guarantee fund) in any EEA State.

31/12/2004

PRU 7.6.49

A UK-deposit insurer must hold admissible assets, which are required to cover its technical provisions in accordance with PRU 7.2.20 R and to represent its EEA MCR in accordance with PRU 7.6.46 R:

(1) (where the assets cover the technical provisions and the guarantee fund) within the EEA states where the firm carries on insurance business;
(2) (where the assets represent the amount of the EEA MCR in excess of the guarantee fund) in any EEA State.

31/12/2004

PRU 7.6.50

PRU 7.6.48 R and PRU 7.6.49 R do not apply to assets covering technical provisions which are debts owed by reinsurers.

31/12/2004

PRU 7.6.51

The admissible assets in excess of the technical provisions and UK or EEA MCR may be held outside the EEA.

31/12/2004

PRU 7.6.52

For the purpose of PRU 7.6.48 R and PRU 7.6.49 R:

(1) a tangible asset is to be treated as held in the country or territory where it is situated;
(2) an admissible asset consisting of a claim against a debtor is to be regarded as held in any country or territory where it can be enforced by legal action;
(3) a listed security is to be treated as held in any country or territory where there is a regulated market in which the security is dealt; and
(4) a security which is not a listed security is to be treated as held in the country or territory in which the issuer has its head office.

31/12/2004

PRU 7.6.53

PRU 4.2.53 R to PRU 4.2.55 R (currency matching of assets and liabilities) apply to the assets held to match insurance liabilities calculated under PRU 7.2.12 R or PRU 7.2.16 R.

31/12/2004

Deposit of assets as security

PRU 7.6.54

A non-EEA direct insurer must keep assets of a value at least equal to one half of the base capital resources requirement on deposit in the United Kingdom with a BCD credit institution.

31/12/2004

PRU 7.6.55

The assets deposited as security may count towards the assets required under PRU 7.6.48 R and PRU 7.6.49 R. If, after the deposit is made, the value of the deposited assets falls below one half of the base capital resources requirement, the firm should deposit further admissible assets in order to comply with PRU 7.6.48 R and PRU 7.6.49 R. Deposited assets may be exchanged for other admissible assets and excess assets may be withdrawn, provided that the exchange or deposit does not cause a breach of PRU 7.6.48 R or PRU 7.6.49 R.

31/12/2004

Branch accounting records in the United Kingdom

PRU 7.6.56

A non-EEA direct insurer must maintain at a place of business in the United Kingdom adequate records relating to:

(1) the activities carried on from its United Kingdom branch; and
(2) if it is an EEA-deposit insurer, the activities carried on from the branches in other EEA States.

31/12/2004

PRU 7.6.57

The records maintained as required by PRU 7.6.56 R must include a record of:

(1) the income, expenditure and liabilities arising from activities of the branch or branches; and
(2) the assets identified under PRU 7.2.20 R as available to meet those liabilities.

31/12/2004

PRU 7 Annex 1G

PRU 7.3 (Mathematical reserves) and PRU 7.4 (With-profits insurance capital component)

31/12/2004

31/12/2004

Export chapter as

Legal Instruments that change this Chapter Insurance risk

PRU 8

Group risk

PRU 8.1

Group risk systems and controls requirement

01/01/2005

Application

PRU 8.1.1

Subject to PRU 8.1.3 R to PRU 8.1.5 R, PRU 8.1 applies to each of the following which is a member of a group:

(1) a firm that falls into any of the following categories:

(a) a regulated entity;
(b) a bank, ELMI or building society;
(c) an insurer;
(d) an own account dealer;
(e) a matched principal broker;
(f) a UCITS investment firm; and
(g) a broker/manager or an arranger that satisfies the following conditions:

(i) it is an ISD investment firm; and
(ii) it is not an exempt CAD firm;

(2) a UCITS firm, but only if its group contains a firm falling into (1); and
(3) the Society.

01/01/2005

PRU 8.1.2

Except as set out in PRU 8.1.5 R, PRU 8.1 applies with respect to different types of group as follows:

(1) PRU 8.1.9 R and PRU 8.1.11 R apply with respect to all groups, including FSA regulated EEA financial conglomerates, other financial conglomerates and groups dealt with in PRU 8.1.14 R and PRU 8.1.15 R;
(2) the additional requirements set out in PRU 8.1.12 R and PRU 8.1.13 R only apply with respect to FSA regulated EEA financial conglomerates; and
(3) the additional requirements set out in PRU 8.1.14 R and PRU 8.1.15 R only apply with respect to groups of the kind dealt with by whichever of those rules apply.

01/01/2005

PRU 8.1.3

PRU 8.1 does not apply to:

(1) an incoming EEA firm; or
(2) an incoming Treaty firm; or
(3) a UCITS qualifier; or
(4) an ICVC.

01/01/2005

PRU 8.1.4

A venture capital firm that would otherwise be included in PRU 8.1.1 R (1)(d) to PRU 8.1.1 R (1)(g) is excluded from those rules if it is not an ISD investment firm.

01/01/2005

PRU 8.1.5

(1) This rule applies to:

(a) PRU 8.1.9 R (2);
(b) PRU 8.1.11 R (1), so far as it relates to PRU 8.1.9 R (2);
(c) PRU 8.1.11 R (2); and
(d) PRU 8.1.12 R to PRU 8.1.14 R.

(2) The rules referred to in (1):

(a) only apply with respect to a financial conglomerate if it is an FSA regulated EEA financial conglomerate;
(b) (so far as they apply with respect to a group that is not a financial conglomerate) do not apply with respect to a group for which a competent authority in another EEA state is lead regulator;
(c) (so far as they apply with respect to a financial conglomerate) do not apply to a firm with respect to a financial conglomerate of which it is a member if the interest of the financial conglomerate in that firm is no more than a participation;
(d) (so far as they apply with respect to other groups) do not apply to a firm with respect to a group of which it is a member if the only relationship of the kind set out in paragraph (3) of the definition of group between it and the other members of the group is nothing more than a participation; and
(e) do not apply with respect to a third-country group.

01/01/2005

PRU 8.1.6

For the purposes of PRU 8.1, a group is defined in the Glossary, and includes the whole of a firm's group, including financial and non-financial undertakings. It also covers undertakings with other links to group members if their omission from the scope of group risk systems and controls would be misleading. The scope of the group systems and controls requirements may therefore differ from the scope of the quantitative requirements for groups.

01/01/2005

Purpose

PRU 8.1.7

The purpose of this chapter is to set out how systems and controls requirements apply where a firm is part of a group. SYSC 3.1 (Systems and controls) requires a firm to take reasonable care to establish and maintain such systems and controls as are appropriate to the nature, scale and complexity of its business. If a firm is a member of a group, it should be able to assess the potential impact of risks arising from other parts of its group as well as from its own activities.

01/01/2005

PRU 8.1.8

PRU 8.1 implements Articles 52(6) (Supervision on a consolidated basis of credit institutions) and 55a (Intra-group transactions with mixed activity holding companies) of the Banking Consolidation Directive, Article 9 of the Financial Groups Directive (Internal control mechanisms and risk management processes) and Article 8 of the Insurance Groups Directive (Intra-group transactions).

01/01/2005

General rules

PRU 8.1.9

A firm must:

(1) have adequate, sound and appropriate risk management processes and internal control mechanisms for the purpose of assessing and managing its own exposure to group risk, including sound administrative and accounting procedures; and
(2) ensure that its group has adequate, sound and appropriate risk management processes and internal control mechanisms at the level of the group, including sound administrative and accounting procedures.

01/01/2005

PRU 8.1.10

For the purposes of PRU 8.1.9 R, the question of whether the risk management processes and internal control mechanisms are adequate, sound and appropriate should be judged in the light of the nature, scale and complexity of the group's business.

01/01/2005

PRU 8.1.11

The internal control mechanisms referred to in PRU 8.1.9 R must include:

(1) mechanisms that are adequate for the purpose of producing any data and information which would be relevant for the purpose of monitoring compliance with any prudential requirements (including any reporting requirements and any requirements relating to capital adequacy, solvency and large exposures):

(a) to which the firm is subject with respect to its membership of a group; or
(b) that apply to or with respect to that group or part of it; and

(2) mechanisms that are adequate to monitor funding within the group.

01/01/2005

Financial conglomerates

PRU 8.1.12

Where PRU 8.1 applies with respect to a financial conglomerate, the risk management processes referred to in PRU 8.1.9 R (2) must include:

(1) sound governance and management processes, which must include the approval and periodic review by the appropriate managing bodies within the financial conglomerate of the strategies and policies of the financial conglomerate in respect of all the risks assumed by the financial conglomerate, such review and approval being carried out at the level of the financial conglomerate;
(2) adequate capital adequacy policies at the level of the financial conglomerate, one of the purposes of which must be to anticipate the impact of the business strategy of the financial conglomerate on its risk profile and on the capital adequacy requirements to which it and its members are subject;
(3) adequate procedures for the purpose of ensuring that the risk monitoring systems of the financial conglomerate and its members are well integrated into their organisation; and
(4) adequate procedures for the purpose of ensuring that the systems and controls of the members of the financial conglomerate are consistent and that the risks can be measured, monitored and controlled at the level of the financial conglomerate.

01/01/2005

PRU 8.1.13

Where PRU 8.1 applies with respect to a financial conglomerate, the internal control mechanisms referred to in PRU 8.1.9 R (2) must include:

(1) mechanisms that are adequate to identify and measure all material risks incurred by members of the financial conglomerate and appropriately relate capital in the financial conglomerate to risks; and
(2) sound reporting and accounting procedures for the purpose of identifying, measuring, monitoring and controlling intra-group transactions and risk concentrations.

01/01/2005

Credit institutions and investment firms

PRU 8.1.14

In the case of a firm that:

(1) is a credit institution or investment firm; and
(2) has a mixed-activity holding company as a parent undertaking;

the risk management processes and internal control mechanisms referred to in PRU 8.1.9 R must include sound reporting and accounting procedures and other mechanisms that are adequate to identify, measure, monitor and control transactions between the firm's parent undertaking mixed-activity holding company and any of the mixed-activity holding company's subsidiary undertakings.

01/01/2005

Insurance undertakings

PRU 8.1.15

In the case of an insurer that has a mixed-activity insurance holding company as a parent undertaking, the risk management processes and internal control mechanisms referred to in PRU 8.1.9 R must include sound reporting and accounting procedures and other mechanisms that are adequate to identify, measure, monitor and control transactions between the firm's parent undertaking mixed-activity insurance holding company and any of the mixed-activity insurance holding company's subsidiary undertakings.

01/01/2005

PRU 8.1.16

PRU 8.1.14 R cannot apply to a building society as it cannot have a mixed-activity holding company as a parent undertaking. PRU 8.1.15 R cannot apply to a friendly society as it cannot have a mixed-activity insurance holding company as a parent undertaking.

01/01/2005

Nature and extent of requirements and allocation of responsibilities within the group

PRU 8.1.17

Assessment of the adequacy of a group's systems and controls required by PRU 8.1 will form part of the FSA's risk management process.

01/01/2005

PRU 8.1.18

The nature and extent of the systems and controls necessary under PRU 8.1.9 R (1) to address group risk will vary according to the materiality of those risks to the firm and the position of the firm within the group.

01/01/2005

PRU 8.1.19

In some cases the management of the systems and controls used to address the risks described in PRU 8.1.9 R (1) may be organised on a group-wide basis. If the firm is not carrying out those functions itself, it should delegate them to the group members that are carrying them out. However, this does not relieve the firm of responsibility for complying with its obligations under PRU 8.1.9 R (1). A firm cannot absolve itself of such a responsibility by claiming that any breach of that rule is caused by the actions of another member of the group to whom the firm has delegated tasks. The risk management arrangements are still those of the firm, even though personnel elsewhere in the firm's group are carrying out these functions on its behalf.

01/01/2005

PRU 8.1.20

PRU 8.1.9 R (1) deals with the systems and controls that a firm should have in respect of the exposure it has to the rest of the group. On the other hand, the purpose of PRU 8.1.9 R (2) and the rules in PRU 8.1 that amplify it is to require groups to have adequate systems and controls. However a group is not a single legal entity on which obligations can be imposed. Therefore the obligations have to be placed on individual firms. The purpose of imposing the obligations on each firm in the group is to make sure that the FSA can take supervisory action against any firm in a group whose systems and controls do not meet the standards in PRU 8.1 Thus responsibility for compliance with the rules for group systems and controls is a joint one.

01/01/2005

PRU 8.1.21

If both a firm and its parent undertaking are subject to PRU 8.1.9 R (2), the FSA would not expect systems and controls to be duplicated. In this case, the firm should assess whether and to what extent it can rely on its parent's group risk systems and controls.

01/01/2005

PRU 8.2

to follow

31/12/2004

PRU 8.3

Group Risk: Insurance Groups

31/12/2004

Application

PRU 8.3.1

PRU 8.3 applies to an insurer that is:

(1) a participating insurance undertaking; or
(2) a member of an insurance group (which is not a participating insurance undertaking).

31/12/2004

PRU 8.3.2

PRU 8.3 does not apply to:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

PRU 8.3.3

PRU 8.3 applies to a firm:

(1) on a solo basis, as an adjusted solo calculation, where that firm is a participating insurance undertaking; and
(2) on a group basis where that firm is a member of an insurance group.

31/12/2004

PRU 8.3.4

For the purposes of PRU 8.3, an insurer includes a pure reinsurer, a friendly society (other than a non-directive friendly society) and a non-EEA insurer.

31/12/2004

Purpose

PRU 8.3.5

The purpose of this section is to implement the Insurance Groups Directive on supplementary supervision of firms in an insurance group, as amended by the Financial Groups Directive. The Financial Groups Directive (by amending the Insurance Directives and the Insurance Groups Directive) introduces specific requirements for the treatment of related undertakings of an insurance parent undertaking or a participating insurance undertaking that are credit institutions, investment firms or financial institutions.

31/12/2004

PRU 8.3.6

PRU 8.3 sets out the sectoral rules for insurers for:

(1) firms that are participating insurance undertakings carrying out an adjusted solo calculation as contemplated by PRU 2.1.9 R (2);
(2) insurance groups; and
(3) insurance conglomerates.

31/12/2004

PRU 8.3.7

For a firm that is a participating insurance undertaking, the rules in PRU 8.3 set out the minimum capital adequacy requirements for the firm itself. A firm that satisfies the test in PRU 8.3.9 R in relation to its group capital resources is deemed by PRU 2.1.9 R (2) to be in compliance with the capital adequacy requirement set out in PRU 2.1.9 R (1).

31/12/2004

Requirement to calculate GCR and GCRR

PRU 8.3.8

A firm must on a regular basis calculate the group capital resources (GCR) and group capital resources requirement (GCRR) of each undertaking referred to in PRU 8.3.17 R.

31/12/2004

Requirement to maintain group capital

PRU 8.3.9

Where a firm is the undertaking referred to in PRU 8.3.17 R (1)(c) or PRU 8.3.17 R (2), it must maintain at all times tier one capital resources and tier two capital resources of such an amount that its group capital resources are equal to or exceed its group capital resources requirement.

31/12/2004

PRU 8.3.10

A firm that is both:

(1) a composite firm; and
(2) an undertaking referred to in PRU 8.3.17 R (1)(c) or PRU 8.3.17 R (2);

must comply with PRU 8.3.9 R separately in respect of its long-term insurance business and its general insurance business.

31/12/2004

PRU 8.3.11

For the purposes of PRU 8.3.10 R, a firm must include in the calculation of the group capital resources and group capital resources requirement of its long-term insurance business the regulated related undertakings and ancillary services undertakings that are long-term insurance assets.

31/12/2004

PRU 8.3.12

PRU 7.6 sets out the detailed requirements for the separation of long-term and general insurance business.

31/12/2004

PRU 8.3.13

In order to comply with PRU 8.3.10 R, a composite firm will need to:

(1) establish the group capital resources requirement of its general insurance business and its long-term insurance business separately; and
(2) allocate its group capital resources between its general insurance business and its long-term insurance business so that:

(a) the group capital resources allocated to its general insurance business are equal to or in excess of the group capital resources requirement of its general insurance business; and
(b) the group capital resources allocated to its long-term insurance business are equal to or in excess of the group capital resources requirement of its long-term insurance business.

31/12/2004

PRU 8.3.14

Surplus group capital resources in the long-term insurance business cannot be used towards meeting the requirements of the general insurance business (see PRU 8.3.41 R) but surplus group capital resources in the general insurance business may be used towards meeting the amount of the group capital resources requirement that relates to the long-term insurance business.

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PRU 8.3.16

Principle 4 requires a firm to maintain adequate financial resources, taking into account any activity of other members of the group of which the firm is a member. PRU 8.3 sets out provisions that deal specifically with the way the activities of other members of the group should be taken into account. This results in the firm being required to hold sufficient capital resources so that the group capital resources are at least equal to the group capital resources requirement. However, the adequacy of the group capital resources needs to be assessed both by the firm and the FSA. Firms are required to carry out an assessment of the adequacy of their financial resources (PRU 1.2.26 R) and the FSA will review this and may provide individual guidance on the amount and quality of capital resources the FSA considers adequate. As part of such reviews, the FSA may also form a view on the appropriateness of the group capital resources requirement and group capital resources. Where necessary, the FSA may also give individual guidance on the capital resources a firm should hold in order to comply with Principle 4 expressed by reference to PRU 8.3.9 R and PRU 8.3.15 R.

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Scope - undertakings whose group capital is to be calculated and maintained

PRU 8.3.17

The undertakings referred to in PRU 8.3.8 R, PRU 8.3.9 R, PRU 8.3.10 R and PRU 8.3.15 Rare:

(1) for any firm that is not within (2), each of the following:

(a) its ultimate insurance parent undertaking;
(b) its ultimate EEA insurance parent undertaking (if different); and
(c) the firm itself, if it is a participating insurance undertaking; and

(2) the firm itself, where the firm is a participating insurance undertaking and is:

(a) a pure reinsurer; or
(b) a non-EEA insurer; or
(c) a friendly society.

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PRU 8.3.18

Article 3(3) of the Insurance Groups Directive allows an undertaking to be excluded from supplementary supervision if:

(1) its head office is in a non-EEA State where there are legal impediments to the transfer of the necessary information; or
(2) in the opinion of the competent authority responsible for exercising supplementary supervision, having regard to the objectives of supplementary supervision:

(a) its inclusion would be inappropriate or misleading; or
(b) it is of neglible interest.

31/12/2004

PRU 8.3.19

If an application is made for a waiver, it is the policy of the FSA to consider the effect, in the circumstances described in PRU 8.3.18 G, of granting a waiver allowing the exclusion of a related undertaking from the calculation of group capital resources and the group capital resources requirement required by PRU 8.3.8 R.

31/12/2004

PRU 8.3.20

Examples of related undertakings which may be excluded from supplementary supervision by Article 3(3) of the Insurance Groups Directive include insurance holding companies in the insurance group that are not the ultimate insurance parent undertaking or, if different, the ultimate EEA insurance parent undertaking of a firm.

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PRU 8.3.21

If more than one member of the insurance group is to be excluded in the circumstances described in PRU 8.3.18 G (2)(b), they may only be excluded if, considered together, they are of negligible interest in the context of the insurance group.

31/12/2004

PRU 8.3.22

When giving a waiver in the circumstances described in PRU 8.3.18 G, the FSA may impose a condition requiring the firm to provide information about any member of the insurance group excluded pursuant to a waiver granted in the circumstances described in PRU 8.3.18 G.

31/12/2004

Optional alternative method of calculation for firms subject to supplementary supervision by another EEA competent authority

PRU 8.3.23

If the competent authority in an EEA State other than the United Kingdom has agreed to be the competent authority responsible for exercising supplementary supervision of an insurance group of which a firm is a member under Article 4(2) of the Insurance Groups Directive, the firm may prepare the calculations required under PRU 8.3.8 R in relation to the ultimate EEA insurance parent undertaking in accordance with the requirements of supplementary supervision in that EEA State.

31/12/2004

PRU 8.3.24

The FSA will notify the firm if it has reached agreement with the competent authority in an EEA State other than the United Kingdom in accordance with Article 4(2) of the Insurance Groups Directive.

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Non-EEA ultimate insurance parent undertakings

PRU 8.3.25

Where the ultimate insurance parent undertaking of a firm has its head office in a non-EEA State, the firm may:

(1) calculate the group capital resources and the group capital resources requirement of its ultimate insurance parent undertaking in accordance with accounting practice applicable for the purposes of the regulation of insurance undertakings in the state or territory of the head office of the ultimate insurance parent undertaking adapted as necessary to apply the general principles set out in Annex I (1) paragraphs B, C and D of the Insurance Groups Directive; and
(2) elect (see PRU 8.3.26 R) to carry out the calculation referred to in (1) in accordance with the accounting consolidation method set out in Annex I (3) of the Insurance Groups Directive.

31/12/2004

PRU 8.3.26

A firm may elect to use the calculation method referred to in PRU 8.3.25 R (2) if it has made the election by written notice to the FSA in a way that complies with the requirements for written notice in SUP 15.7.

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PRU 8.3.27

PRU 8.3.15 R does not apply in respect of the group capital resources of a firm's ultimate insurance parent undertaking if that ultimate insurance parent undertaking has its head office in a non-EEA State.

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Proportional holdings

PRU 8.3.28

Subject to PRU 8.3.30 R and PRU 8.3.31 R, when calculating group capital resources and the group capital resources requirement of an undertaking in PRU 8.3.17 R, a firm must take only the relevant proportion of the following items ("calculation items") into account:

(1) the solo capital resources of a regulated related undertaking;
(2) the assets of a regulated related undertaking which are required to be deducted as part of the calculation of group capital resources; and
(3) the individual capital resources requirement of a regulated related undertaking.

31/12/2004

PRU 8.3.29

In PRU 8.3.28 R, the relevant proportion is either:

(1) the proportion of the total number of issued shares in the regulated related undertaking held, directly or indirectly, by the undertaking in PRU 8.3.17 R; or
(2) where a consolidation Article 12(1) relationship exists between related undertakings within the insurance group, such proportion as the FSA determines in accordance with Article 28(5) of the Financial Groups Directive and Regulation 15 of the Financial Groups Directive Regulations.

31/12/2004

PRU 8.3.30

Where the undertaking in PRU 8.3.17 R is a firm, if the individual capital resources requirement of a regulated related undertaking that is a subsidiary undertaking and not an insurer exceeds the solo capital resources of that undertaking less the amount calculated in PRU 8.3.74 R (3) (if any), the full amount of the calculation items of that regulated related undertaking less the amount in PRU 8.3.74 R (3) must be taken into account in the calculation of group capital resources and the group capital resources requirement.

31/12/2004

PRU 8.3.31

Except where PRU 8.3.30 R applies, if the individual capital resources requirement of a regulated related undertaking that is a subsidiary undertaking of the undertaking in PRU 8.3.17 R exceeds its solo capital resources, the full amount of the calculation items of that regulated related undertaking must be taken into account in the calculation of group capital resources and the group capital resources requirement.

31/12/2004

PRU 8.3.32

For the purposes of PRU 8.3.10 R, where a composite firm that is an undertaking in PRU 8.3.17 R (1)(c) or (2):

(1) holds directly or indirectly shares in a regulated related undertaking; and
(2) the shares in (1) are held partly by its long-term insurance business and partly by its general insurance business;
(3) the relevant proportion of the calculation items calculated in accordance with PRU 8.3.29 R, subject to PRU 8.3.30 R and PRU 8.3.31 R, must be allocated between the long-term and general insurance business in proportion to their respective holdings, directly or indirectly, in the shares in that regulated related undertaking.

31/12/2004

Calculation of the GCRR

PRU 8.3.33

Subject to PRU 8.3.23 R and PRU 8.3.25 R, a firm must calculate the group capital resources requirement of an undertaking in PRU 8.3.17 R as the sum of the individual capital resources requirement of that undertaking and the individual capital resources requirement of each of its regulated related undertakings.

31/12/2004

PRU 8.3.34

For the purposes of PRU 8.3, an individual capital resources requirement is:

(1) in respect of an insurer that is not within (2):

(a) its capital resources requirement calculated in accordance with PRU 2.1; less
(b) where the capital resources requirements of both the insurer and its insurance parent undertaking that is an insurer include with-profits insurance capital components, any element of double-counting that may arise from the aggregation of the individual capital resources requirements for the purposes of PRU 8.3.33 R;

(2) in respect of an insurer that is either a pure reinsurer or whose main business otherwise consists of reinsurance, and whose head office is in the United Kingdom, the capital resources requirement that would apply to the firm in accordance with PRU 2.1 if its insurance business was not restricted to reinsurance;
(3) in respect of an insurance undertaking that is not within (1) or (2) and whose main business is reinsurance and whose head office is in a designated State or territory, either:

(a) the proxy capital resources requirement that would apply to it if, in connection with its reinsurance activities, the permissions on the basis of which that proxy capital resources requirement is calculated were permissions to carry on insurance business that is not restricted to reinsurance; or
(b) the solo capital resources requirement that would apply to it if, in connection with its reinsurance activities, the insurance undertaking were a regulated insurance entity whose insurance business is not restricted to reinsurance for the purposes of calculating the solo capital resources requirement in accordance with the relevant sectoral rules of the designated State or territory;

(4) in respect of an insurance undertaking that is not within (1) to (3) and whose main business is reinsurance, the proxy capital resources requirement that would apply to it if, in connection with its reinsurance activities, the permissions on the basis of which that proxy capital resources requirement is calculated were permissions to carry on insurance business that is not restricted to reinsurance;
(5) in respect of an EEA insurer, the equivalent of the capital resources requirement as calculated in accordance with the applicable requirements in its Home State;
(6) in respect of an insurance undertaking that is not within (1) to (5) and whose head office is in a designated State or territory, either:

(a) the solo capital resources requirement applicable to it in that designated State or territory; or
(b) its proxy capital resources requirement;

(7) in respect of an insurance undertaking that is not within (1) to (6), its proxy capital resources requirement;
(8) in respect of a regulated entity with its head office in the EEA (excluding an insurance undertaking), its solo capital resources requirement calculated in accordance with the sectoral rules for the financial sector applicable to it in the EEA State in which it has its head office;
(9) in respect of a regulated entity not within (8) (excluding an insurance undertaking), its solo capital resources requirement;
(10) in respect of an asset management company, the solo capital resources requirement that would apply to it if, in connection with its activities, it were treated as an investment firm for the purposes of calculating the solo capital resources requirement;
(11) in respect of a financial institution that is not a regulated entity (including a financial holding company), the solo capital resources requirement that would apply to it if, in connection with its activities, it were treated as being within the banking sector; and
(12) in respect of an insurance holding company, zero.

31/12/2004

PRU 8.3.35

The Insurance Groups Directive defines reinsurers in terms of the 'main business' they carry on. Under the directive, the individual capital resources requirements for reinsurers (including those whose head office is in the United Kingdom) are to be calculated on the basis of requirements analogous to those applicable to direct insurers (that is, insurers carrying on insurance business that is not restricted to reinsurance). Although insurers that are pure reinsurers are already subject to PRU, there are a number of respects in which the capital regime that applies to them differs from that applicable to insurers who are direct insurers. The effect of PRU 8.3.34 R (2) to (4) is to calculate the individual capital resources requirement for all reinsurers as if they were carrying on direct insurance. This applies to:

(1) pure reinsurers whose head office is in the United Kingdom;
(2) insurers whose head office is in the United Kingdom and whose main business is reinsurance (because an insurer that is not a pure reinsurer with their business restricted to reinsurance may nevertheless in principle still have reinsurance as its main business);
(3) reinsurers whose head office is in another EEA State;
(4) reinsurers whose head office is in a designated State or territory (other than an EEA State); and
(5) reinsurers whose head office is outside the EEA.

31/12/2004

Calculation of GCR

PRU 8.3.36

For the purposes of PRU 8.3.8 R and subject to PRU 8.3.23 R and PRU 8.3.25 R, a firm must calculate the group capital resources of an undertaking in PRU 8.3.17 R in accordance with the table in PRU 8.3.43 R, subject to the limits in PRU 8.3.45 R.

31/12/2004

PRU 8.3.37

For the purposes of PRU 8.3, the following expressions when used in relation to either an undertaking in PRU 8.3.17 R or a regulated related undertaking which is not subject to PRU 2.2.14 R, are to be construed as if that undertaking were required to calculate its capital resources in accordance with PRU 2.2.14 R, but with such adjustments being made to secure that the undertaking's calculation of its solo capital resources complies with the relevant sectoral rules applicable to it:

(1) tier one capital resources;
(2) tier two capital resources;
(3) upper tier two capital resources;
(4) lower tier two capital resources;
(5) innovative tier one capital resources; and
(6) core tier one capital.

31/12/2004

PRU 8.3.38

For the purposes of PRU 8.3.37 R, the sectoral rules applicable to:

(1) an insurance holding company are the sectoral rules that would apply to it if, in connection with its activities, it were treated as an insurer;
(2) an asset management company are the sectoral rules that would apply to it if, in connection with its activities, it were treated as an investment firm; and
(3) subject to PRU 8.3.39 R, a financial institution, that is not a regulated entity, are the sectoral rules that would apply to it if, in connection with its activities, it were treated as being within the banking sector.

31/12/2004

PRU 8.3.39

Where a financial institution, that is not a regulated entity, has invested in tier one capital or tier two capital issued by a parent undertaking that is:

(1) an insurance holding company; or
(2) an insurer;

the sectoral rules that apply to that financial institution are the sectoral rules for the insurance sector.

31/12/2004

PRU 8.3.40

For the purposes of PRU 8.3.36 R, the capital resources of a financial institution within PRU 8.3.39 R that can be included in the calculations in PRU 8.3.48 R (2), PRU 8.3.50 R (2), PRU 8.3.53 R (2), PRU 8.3.55 R (2) and PRU 8.3.57 R (2) are:

(1) the issued tier one capital or tier two capital of that financial institution held, directly or indirectly, by its parent undertaking referred to in PRU 8.3.39 R; and
(2) the lower of:

(a) the tier one capital or tier two capital issued by the parent undertaking referred to in PRU 8.3.39 R pursuant to the investment by the financial institution; and
(b) the tier one capital or tier two capital issued by the financial institution to raise funds for its investment in the capital resources of the parent undertaking referred to in (a).

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PRU 8.3.41

(1) In calculating group capital resources, a firm must exclude the restricted assets of a regulated related undertaking except insofar as those assets are available to meet the individual capital resources requirement of that regulated related undertaking.
(2) In (1), "restricted assets" means assets of a regulated related undertaking which are subject to a legal restriction or other requirement having the effect that those assets cannot be transferred or otherwise made available to another regulated related undertaking for the purposes of meeting its individual capital resources requirement without causing a breach of that legal restriction or requirement.

31/12/2004

PRU 8.3.42

For the purposes of PRU 8.3.41 R, in respect of an insurance undertaking that is a member of an insurance group, the assets of a long-term insurance fund are restricted assets within the meaning of PRU 8.3.41 R. Any excess of assets over liabilities in the long-term insurance business may only be included in the calculation of the group capital resources up to the amount of the capital resources requirement related to that long-term insurance business.

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PRU 8.3.43

Table: Group capital resources

Stage

Related text

Total group tier one capital

PRU 8.3.48 R

Total group tier two capital

PRU 8.3.50 R

Group capital resources before deductions

C=(A+B)

Total deductions of inadmissible assets

PRU 8.3.59 R

Total deductions under the requirement deduction method from group capital resources

PRU 8.3.62 R

Total deductions of ineligible surplus capital*

PRU 8.3.65 R

Deduction of assets in excess of market risk and counterparty exposure limits*

PRU 8.3.70 R

Group capital resources

H=(C-(D+E+F*+G*))

* = section (F) of the table (the deductions for ineligible surplus capital) and section (G) of the table (assets in excess of market risk and counterparty exposure limits) only apply and are required to be calculated for the purposes of the adjusted solo calculation of an undertaking in PRU 8.3.17 R that is a participating insurance undertaking.

31/12/2004

Calculation of GCR - Limits on the use of different forms of capital

PRU 8.3.44

As the various components of capital differ in the degree of protection that they offer the insurance group, restrictions are placed on the extent to which certain types of capital are eligible for inclusion in the group capital resources of the undertaking in PRU 8.3.17 R. These restrictions are set out in PRU 8.3.45 R.

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PRU 8.3.45

(1) For the purposes of PRU 8.3.9 R, PRU 8.3.10 R and PRU 8.3.15 R, a firm must ensure that at all times its tier one capital resources and tier two capital resources are of such an amount that the group capital resources of the undertaking in PRU 8.3.17 R comply with the following limits:

(a) (P - Q) > ½ (R - S);
(b) (P - Q + T - W) > ¾ (R - S);
(c) V > ½ P;
(d) Q < 15% of P;
(e) T < P; and
(f) W < ½ P

(2) For the purposes of PRU 8.3.9 R and PRU 8.3.10 R, a firm must ensure that at all times its tier one capital resources and tier two capital resources are of such an amount that its group capital resources comply with the following limit:

(P - Q + T) > 1/3 X + (R - S - U - X).

(3) For the purposes of (1) and (2):

(a) P is the total group tier one capital of the undertaking in PRU 8.3.17 R;
(b) Q is the sum of the innovative tier one capital resources calculated in accordance with PRU 8.3.53 R;
(c) R is the group capital resources requirement of the undertaking in PRU 8.3.17 R;
(d) S is the sum of all the with-profits insurance capital components of an undertaking in PRU 8.3.17 R that is an insurer and each of its regulated related undertakings that is an insurer;
(e) T is the total group tier two capital of the undertaking in PRU 8.3.17 R;
(f) U is the sum of all the resilience capital requirements of an undertaking in PRU 8.3.17 R that is an insurer and each of its regulated related undertakings that is an insurer;
(g) V is the sum of all the core tier one capital calculated in accordance with PRU 8.3.55 R;
(h) W is the sum of the lower tier two capital resources calculated in accordance with PRU 8.3.57 R; and
(i) X is the MCR of the firm less its resilience capital requirement, if any.

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PRU 8.3.46

The amount of any capital item excluded from group capital resources under PRU 8.3.45 R (1)(d) may form part of total group tier two capital calculated in accordance with PRU 8.3.50 R subject to the limits in PRU 8.3.45 R (1)(e) and (f).

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PRU 8.3.47

For the purposes of PRU 8.3.10 R, a firm must ensure that the tier one capital resources and tier two capital resources of each of its long-term insurance business and its general insurance business are of such an amount that the group capital resources of each its long-term insurance business and its general insurance business comply with the limits in PRU 8.3.45 R separately for each type of business.

31/12/2004

Calculation of GCR - Total group tier one capital

PRU 8.3.48

For the purposes of PRU 8.3.43 R, the total group tier one capital of an undertaking in PRU 8.3.17 R is the sum of:

(1) the tier one capital resources of the undertaking in PRU 8.3.17 R; and
(2) subject to PRU 8.3.40 R, the tier one capital resources of each of the related undertakings of that undertaking that is a regulated related undertaking after the deduction in PRU 8.3.49 R.

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PRU 8.3.49

The deduction referred to in PRU 8.3.48 R is the sum of:

(1) the book value of the investment by the undertaking in PRU 8.3.17 R in the tier one capital resources of each of its related undertakings that is a regulated related undertaking; and
(2) the book value of the investments by related undertakings of the undertaking in PRU 8.3.17 R in the tier one capital resources of the undertaking in PRU 8.3.17 R and each of its related undertakings that is a regulated related undertaking.

31/12/2004

Calculation of GCR - Total group tier two capital

PRU 8.3.50

For the purposes of PRU 8.3.43 R, the total group tier two capital of an undertaking in PRU 8.3.17 R is the sum of:

(1) the upper tier two capital resources and the lower tier two capital resources of that undertaking; and
(2) subject to PRU 8.3.40 R, the upper tier two capital resources and the lower tier two capital resources of each of the related undertakings of that undertaking that is a regulated related undertaking after the deduction in PRU 8.3.51 R.

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PRU 8.3.51

The deduction referred to in PRU 8.3.50 R is the sum of:

(1) the book value of the investments by the undertaking in PRU 8.3.17 R in the upper tier two capital resources and the lower tier two capital resources of each of its related undertakings that is a regulated related undertaking; and
(2) the book value of the investments by related undertakings of the undertaking in PRU 8.3.17 R in the upper tier two capital resources and the lower tier two capital resources of the undertaking in PRU 8.3.17 R and each of its related undertakings that is a regulated related undertaking.

31/12/2004

PRU 8.3.52

For the purposes of PRU 8.3.50 R (2), the limits in PRU 2.2.23 R apply to the upper tier two capital resources and the lower tier two capital resources of any regulated related undertaking that is an insurer. Similar limits may apply to other regulated related undertakings under the relevant sectoral rules.

31/12/2004

Calculation of GCR - Innovative tier one capital resources, lower tier two capital resources and core tier one capital

PRU 8.3.53

For the purposes of PRU 8.3.45R (3)(b), the innovative tier one capital resources is the sum of:

(1) the innovative tier one capital resources of the undertaking in PRU 8.3.17 R; and
(2) subject to PRU 8.3.40 R, the innovative tier one capital resources of each of the related undertakings of that undertaking that is a regulated related undertaking after the deduction in PRU 8.3.54 R.

31/12/2004

PRU 8.3.54

The deduction referred to in PRU 8.3.53 R is the sum of:

(1) the book value of the investments by the undertaking in PRU 8.3.17 R in the innovative tier one capital resources of each of its related undertakings that is a regulated related undertaking; and
(2) the book value of the investments by related undertakings of the undertaking in PRU 8.3.17 R in the innovative tier one capital resources of the undertaking in PRU 8.3.17 R and each of its related undertakings that is a regulated related undertaking.

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PRU 8.3.55

For the purposes of PRU 8.3.45R (3)(g), the core tier one capital is the sum of:

(1) the core tier one capital of the undertaking of PRU 8.3.17 R; and
(2) subject to PRU 8.3.40 R, the core tier one capital of each of the related undertakings of that undertaking that is a regulated related undertaking after the deduction in PRU 8.3.56 R.

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PRU 8.3.56

The deduction referred to in PRU 8.3.55 R is the sum of:

(1) the book value of the investments by the undertaking in PRU 8.3.17 R in the core tier one capital of each of its related undertakings that is a regulated related undertaking; and
(2) the book value of the investments by related undertakings of the undertaking in PRU 8.3.17 R in the core tier one capital of the undertaking in PRU 8.3.17 R and each of its related undertakings that is a regulated related undertaking.

31/12/2004

PRU 8.3.57

For the purposes of PRU 8.3.45R (3)(h), the lower tier two capital resources is the sum of:

(1) the lower tier two capital resources of the undertaking in PRU 8.3.17 R; and
(2) subject to PRU 8.3.40 R, the lower tier two capital resources of each of the related undertakings of that undertaking that is a regulated related undertaking after the deduction in PRU 8.3.58 R.

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PRU 8.3.58

The deduction referred to in PRU 8.3.57 R is the sum of:

(1) the book value of the investments by the undertaking in PRU 8.3.17 R in the lower tier two capital resources of each of its related undertakings that is a regulated related undertaking; and
(2) the book value of the investments by related undertakings of the undertaking in PRU 8.3.17 R in the lower tier two capital resources of the undertaking in PRU 8.3.17 R and each of its related undertakings that is a regulated related undertaking.

31/12/2004

Calculation of GCR - Inadmissible assets

PRU 8.3.59

For the purpose of PRU 8.3.43 R, a firm must deduct from the group capital resources before deduction (calculated at stage C in the table in PRU 8.3.43 R) of the undertaking in PRU 8.3.17 R, the value of all assets of the undertaking in PRU 8.3.17 R and each of its regulated related undertakings that are not admissible assets as set out in PRU 8.3.60 R.

31/12/2004

PRU 8.3.60

For the purposes of PRU 8.3.59 R, an asset is not an admissible asset if:

(1) in respect of a regulated related undertaking or undertaking in PRU 8.3.17 R that is an insurer, it is not an admissible asset as listed in PRU 2 Annex 1R;
(2) in respect of a regulated related undertaking or undertaking in PRU 8.3.17 R that is not an insurer, it is an asset of the undertaking that is not admissible for the purpose of calculating that undertaking's solo capital resources in accordance with the sectoral rules applicable to it.

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PRU 8.3.61

For the purposes of PRU 8.3.60 R (2), the sectoral rules applicable to:

(1) an asset management company are the sectoral rules that would apply to it if, in connection with its activities, it were treated as an investment firm; and
(2) a financial institution that is not a regulated entity are the sectoral rules that would apply to it if, in connection with its activities, it were treated as being within the banking sector.

31/12/2004

Calculation of GCR - Deductions under requirement deduction method from group capital resources

PRU 8.3.62

For the purposes of PRU 8.3.43 R, a firm must deduct from the group capital resources before deduction (calculated at stage C in the table in PRU 8.3.43 R) of an undertaking in PRU 8.3.17 R, the sum of the value of the direct or indirect investments by the undertaking in PRU 8.3.17 R in each of its related undertakings which is an ancillary services undertaking, calculated in accordance with PRU 8.3.63 R.

31/12/2004

PRU 8.3.63

The value of an investment in an undertaking referred to in PRU 8.3.62 R is the higher of the book value of the direct or indirect investment by the undertaking in PRU 8.3.17 R and the notional capital resources requirement of that undertaking.

31/12/2004

PRU 8.3.64

For the purposes of PRU 8.3.63 R, the notional capital resources requirement is:

(1) for an ancillary insurance services undertaking, zero;
(2) for any other ancillary services undertaking, the capital resources requirement that would apply to that undertaking, if it were a regulated related undertaking, in accordance with the sectoral rules applicable to a regulated related undertaking whose activities are closest in nature and scope to the activities of that undertaking.

31/12/2004

Calculation of GCR - Deductions of ineligible surplus capital

PRU 8.3.65

Where the undertaking in PRU 8.3.17 R is a participating insurance undertaking, the firm must, for the purposes of PRU 8.3.43 R, deduct from its group capital resources before deduction (calculated at stage C in the table in PRU 8.3.43 R) the sum of the ineligible surplus capital of each of its regulated related undertakings that is an insurance undertaking, calculated in accordance with PRU 8.3.67 R.

31/12/2004

PRU 8.3.66

The purpose of PRU 8.3.65 R is to ensure that, where the undertaking in PRU 8.3.17 R is a firm, group capital resources are not overstated by the inclusion of capital that, although surplus to the requirements of the relevant regulated related undertaking that is an insurance undertaking, cannot practically be transferred to support requirements arising elsewhere in the group. Therefore, ineligible surplus capital in a regulated related undertaking that is an insurance undertaking is deducted in arriving at group capital resources. Surplus capital in such a regulated related undertaking is regarded as transferable only to the extent that:

(1) it can be transferred without the regulated related undertaking breaching its own limits on the use of different forms of capital;
(2) it does not contain assets that are restricted within the meaning of PRU 8.3.41 R; and
(3) in the case of a regulated related undertaking that has a long-term insurance business, it does not contain any assets allocated to the capital resources of that undertaking for the purposes of the capital resources of its long-term insurance business meeting the capital resources requirement of its long-term insurance business.

31/12/2004

PRU 8.3.67

(1) For the purposes of PRU 8.3.65 R, the ineligible surplus capital of a regulated related undertaking that is an insurance undertaking is calculated by deducting B from A where:

(a) A is the regulatory surplus value of that insurance undertaking less any restricted assets of the insurance undertaking that have been excluded under PRU 8.3.41 R; and
(b) B is the transferable capital of that undertaking.

(2) If A minus B is negative, the ineligible surplus capital is zero.

31/12/2004

PRU 8.3.68

For the purposes of PRU 8.3.67 R (1)(b), the transferable capital is calculated by deducting the sum of the following from the tier one capital resources of the regulated related undertaking that is an insurance undertaking:

(1) any restricted assets of that insurance undertaking that have been excluded under PRU 8.3.41 R;
(2) any tier one capital resources of that insurance undertaking that have been allocated towards meeting the individual capital resources requirement of its long-term insurance business; and
(3) the higher of:

(a) 50% of the individual capital resources requirement of the general insurance business of that insurance undertaking; and
(b) the individual capital resources requirement of the general insurance business of that insurance undertaking less the difference between E and F where:

(i) E is its tier two capital resources; and
(ii) F is the amount of its tier two capital resources that have been allocated towards meeting the individual capital resources requirement of its long-term insurance business.

31/12/2004

PRU 8.3.69

Examples of transferable and ineligible surplus capital:

Example 1

Share capital

Audited reserves

FFA

Tier two

Requirement

(i) Under PRU 8.3.68 R, transferable capital = tier one capital resources of 50, less the sum of:

(1) restricted assets excluded under PRU 8.3.41 R = (none);
(2) tier one capital resources allocated to the long-term insurance business = (none); and
(3) higher of (50% of 50 = 25 and 50 - 40 = 10) = (25) = (50 - 25) = 25

(2) Under PRU 8.3.67 R, ineligible surplus capital = regulatory surplus value (40) less restricted assets excluded under PRU 8.3.41 R (0) less transferable capital (25) = 15.

Example 2

Share capital

Audited reserves

FFA (of which 5 is restricted)

Tier two

Requirement (of which 4 relates to the long-term insurance business)

(i) Under PRU 8.3.68 R, transferable capital = tier one capital resources of 60, less the sum of:

(1) restricted assets excluded under PRU 8.3.41 R = (5);
(2) tier one capital resources allocated to the long-term insurance business = (5); and
(3) the higher of (50% of 45 = 22.5; and 45 - 40 = 5) = (22.5)= 60 - 32.5 = 27.5

(ii) Under PRU 8.3.67 R, ineligible surplus capital = regulatory surplus value (50) - restricted assets excluded under PRU 8.3.41 R of (5) - transferable capital (27.5) = 17.5.

Example 3

Share capital

Audited reserves

FFA (of which 0 is restricted)

Tier two (40, of which 5 is excluded at the solo level - see below)

Requirement (of which 25 relates to the long-term insurance business)

The requirement relating to the long-term insurance business is met by the FFA of 20 and tier two capital resources of 5. Of the remaining tier two capital resources of 35, 5 is excluded at the solo level because the tier one capital resources allocated to the general insurance business are 30.

(i) Under PRU 8.3.68 R, transferable capital = tier one capital resources of 50, less the sum of:

(1) restricted assets excluded under PRU 8.3.41 R = (none);
(2) tier one capital resources allocated to the long-term insurance business = (20); and
(3) the higher of (50% of 25 = 12.5; and 25 - (35 - 5) = -5) = (12.5)= 50 - 32.5 = 17.5.

(ii) Under PRU 8.3.67 R, ineligible surplus capital = regulatory surplus value (35) - restricted assets excluded under PRU 8.3.41 R of (0) - transferable capital (17.5) = 17.5.

31/12/2004

Calculation of GCR - Assets in excess of market risk and counterparty exposure limits

PRU 8.3.70

Where the undertaking in PRU 8.3.17 R is a participating insurance undertaking, the firm must deduct from its group capital resources before deduction (calculated at stage C in the table in PRU 8.3.43 R) the assets in excess of market risk and counterparty exposure limits calculated in accordance with PRU 8.3.74 R.

31/12/2004

PRU 8.3.71

For the purposes of PRU 8.3.43 R, where the undertaking in PRU 8.3.17 R is a participating insurance undertaking, the investments referred to in PRU 8.3.48 R and PRU 8.3.50 R are not subject to the market risk and counterparty exposure limits.

31/12/2004

PRU 8.3.72

The firm (A) must, subject to PRU 8.3.73 R, include in the calculation in PRU 8.3.74 R each related undertaking (B) that is:

(1) a regulated related undertaking that is a subsidiary undertaking; or
(2) a related undertaking where the firm has elected to value the shares held in that undertaking by the firm in accordance with PRU 1.3.35 R for the purposes of calculating the tier one capital resources of the firm.

31/12/2004

PRU 8.3.73

The related undertakings in PRU 8.3.72 R need only be included in the calculation in PRU 8.3.74 R if:

(1) where B is a regulated related undertaking, the solo capital resources of that undertaking exceed its individual capital resources requirement; or
(2) where B is an undertaking in PRU 8.3.72 R (2), its assets that fall within one or more of the categories in PRU 2 Annex 1R exceed its accounting liabilities.

31/12/2004

PRU 8.3.74

A's assets in excess of the market risk and counterparty exposure limits are calculated as follows:

(1) Subject to (2), a firm must apply the market risk and counterparty exposure limits in PRU 3.2.22 R (3) to:

(a) where B is an insurer, the admissible assets of B;
(b) where B is a regulated related undertaking that is not an insurer, the assets of that undertaking less those assets identified in PRU 8.3.60 R (2) as not being admissible assets.

(2) The market risk and counterparty exposure limits do not need to be applied to an undertaking in PRU 8.3.72 R (2).
(3) Where the assets of B in PRU 8.3.74 R (1) exceed the limits in PRU 3.2.22 R (3), the assets of B in excess of the limits must be deducted by the firm from B's solo capital resources for the purposes of PRU 8.3.30 R.
(4) After the application of (1) and (2), the surplus assets of B are aggregated with the admissible assets of A, where the surplus assets of B are:

(a) where B is a firm, the admissible assets of B that represent the amount by which the capital resources of B exceed its capital resources requirement, subject to PRU 8.3.77 R, and limited to the amount of transferable capital calculated in accordance with PRU 8.3.68 R;
(b) where B is a regulated related undertaking that is not a firm, the assets of the undertaking in PRU 8.3.74 R (1)(b) that represent the amount by which the solo capital resources of B exceed its individual capital resources requirement and, where B is an insurance undertaking that is not a firm, limited to the amount of transferable capital calculated in accordance with PRU 8.3.68 R; and
(c) where B is an undertaking in PRU 8.3.72 R (2), the assets of the undertaking which represent those assets that fall within one or more of the categories in PRU 2 Annex 1R which exceed its accounting liabilities.

(5) The market risk and counterparty exposure limits are then applied to the aggregate of A's admissible assets and the surplus assets in PRU 8.3.74 R (4).

31/12/2004

PRU 8.3.75

The firm (A) must then deduct the amount by which the admissible assets aggregated in accordance with PRU 8.3.74 R (5) exceed the market risk and counterparty exposure limits from A's group capital resources before deduction (calculated at stage C in the table in PRU 8.3.43 R) in accordance with PRU 8.3.70 R.

31/12/2004

PRU 8.3.76

In relation to any of its regulated related undertakings that is not an insurer, A may modify the calculation in PRU 8.3.74 R by:

(1) omitting the calculation in PRU 8.3.74 R (1) and (3); and
(2) aggregating all of the assets of B identified in PRU 8.3.74 R (1)(b) as admissible assets with the admissible assets of A in PRU 8.3.74 R (4).

31/12/2004

PRU 8.3.77

The admissible assets of either A or B that are part of a long-term insurance fund of A or B are excluded for the purposes of the calculation in PRU 8.3.74 R except insofar as those assets are available to meet the liabilities and capital resources requirement of that long-term insurance fund.

31/12/2004

PRU 8.3.78

If B is itself either a participating insurance undertaking or an insurance parent undertaking, the admissible assets of B for the purposes of PRU 8.3.74 R (1) must be calculated as in PRU 8.3.75 R but as if B were A.

31/12/2004

PRU 8.4

Cross sector groups

01/12/2004

Application

PRU 8.4.1

(1) PRU 8.4 applies to every firm that is a member of a financial conglomerate other than:

(a) an incoming EEA firm;
(b) an incoming Treaty firm;
(c) a UCITS qualifier; and
(d) an ICVC.

(2) PRU 8.4 does not apply to a firm with respect to a financial conglomerate of which it is a member if the interest of the financial conglomerate in that firm is no more than a participation.
(3) PRU 8.4.25 R (Capital adequacy requirements: high level requirement), PRU 8.4.26 R (Capital adequacy requirements: application of Method 4 from Annex I of the Financial Groups Directive), PRU 8.4.29 R (Capital adequacy requirements: application of Methods 1, 2 or 3 from Annex I of the Financial Groups Directive) and PRU 8.4.35 R (Risk concentration and intra group transactions: the main rule) do not apply with respect to a third-country financial conglomerate.

11/08/2004

Purpose

PRU 8.4.2

PRU 8.4 implements the Financial Groups Directive. However, material on the following topics is to be found elsewhere in the Handbook as follows:

(1) further material on third-country financial conglomerates can be found in PRU 8.5;
(2) SUP 15.9 contains notification rules for members of financial conglomerates;
(3) material on reporting obligations can be found in SUP 16.7.73 R and SUP 16.7.74 R; and
(4) material on systems and controls in financial conglomerates can be found in PRU 8.1.

11/08/2004

Introduction: identifying a financial conglomerate

PRU 8.4.3

(1) In general the process in (2) to (8) applies for identifying financial conglomerates.
(2) Competent authorities that have authorised regulated entities should try to identify any consolidation group that is a financial conglomerate. If a competent authority is of the opinion that a regulated entity authorised by that competent authority is a member of a consolidation group which may be a financial conglomerate it should communicate its view to the other competent authorities concerned.
(3) A competent authority may start (as described in (2)) the process of deciding whether a group is a financial conglomerate even if it would not be the coordinator.
(4) A member of a group may also start that process by notifying one of the competent authorities that have authorised group members that its group may be a financial conglomerate, for example by notification under SUP 15.9.
(5) If a group member gives a notification in accordance with (4), that does not automatically mean that the group should be treated as a financial conglomerate. The process described in (6) to (9) still applies.
(6) The competent authority that would be coordinator will take the lead in establishing whether a group is a financial conglomerate once the process has been started as described in (2) and (3).
(7) The process of establishing whether a group is a financial conglomerate will normally involve discussions between the financial conglomerate and the competent authorities concerned.
(8) A financial conglomerate should be notified by its coordinator that it has been identified as a financial conglomerate and of the appointment of the coordinator. The notification should be given to the parent undertaking at the head of the group or, in the absence of a parent undertaking, the regulated entity with the largest balance sheet total in the most important financial sector. That notification does not of itself make a group into a financial conglomerate; whether or not a group is a financial conglomerate is governed by the definition of financial conglomerate as set out in PRU 8.4.
(9) PRU 8 Ann 4R is a questionnaire (together with its explanatory notes) that the FSA asks groups that may be financial conglomerates to fill out in order to decide whether or not they are.

11/08/2004

Introduction: The role of other competent authorities

PRU 8.4.4

A lead supervisor (called the coordinator) is appointed for each financial conglomerate. Article 10 of the Financial Groups Directive describes the criteria for deciding which competent authority is appointed as coordinator. Article 11 of the Financial Groups Directive sets out the tasks of the coordinator.

11/08/2004

Definition of financial conglomerate: basic definition

PRU 8.4.5

A financial conglomerate means a consolidation group that is identified as a financial conglomerate in accordance with the decision tree in PRU 8 Ann 3G G.

31/12/2004

Definition of financial conglomerate: sub-groups

PRU 8.4.6

A consolidation group is not prevented from being a financial conglomerate because it is part of a wider:

(1) consolidation group; or
(2) financial conglomerate; or
(3) group of persons linked in some other way.

11/08/2004

Definition of financial conglomerate: the financial sectors: general

PRU 8.4.7

For the purpose of the definition of financial conglomerate, there are two financial sectors as follows:

(1) the banking sector and the investment services sector, taken together; and
(2) the insurance sector.

11/08/2004

PRU 8.4.8

(1) This rule applies for the purpose of the definition of financial conglomerate and the financial conglomerate definition decision tree.
(2) Any mixed financial holding company is considered to be outside the overall financial sector for the purpose of the tests set out in the boxes titled Threshold Test 1, Threshold Test 2 and Threshold Test 3 in the financial conglomerate definition decision tree.
(3) Determining whether the tests set out in the boxes titled Threshold Test 2 and Threshold Test 3 in the financial conglomerate definition decision tree are passed is based on considering the consolidated and/or aggregated activities of the members of the consolidation group within the insurance sector and the consolidated and/or aggregated activities of the members of the consolidation group within the banking sector and the investment services sector.

11/08/2004

Definition of financial conglomerate: adjustment of the percentages

PRU 8.4.9

Once a financial conglomerate has become a financial conglomerate and subject to supervision in accordance with the Financial Groups Directive, the figures in the financial conglomerate definition decision tree are altered as follows:

(1) the figure of 40% in the box titled Threshold Test 1 is replaced by 35%;
(2) the figure of 10% in the box titled Threshold Test 2 is replaced by 8%; and
(3) the figure of six billion Euro in the box titled Threshold Test 3 is replaced by five billion Euro.

11/08/2004

PRU 8.4.10

The alteration in PRU 8.4.9 R only applies to a financial conglomerate during the period that:

(1) begins when the financial conglomerate would otherwise have stopped being a financial conglomerate because it does not meet one of the unaltered thresholds referred to in PRU 8.4.9 R; and
(2) covers the three years following that date.

11/08/2004

Definition of financial conglomerate: balance sheet totals

PRU 8.4.11

The calculations referred to in the financial conglomerate definition decision tree regarding the balance sheet must be made on the basis of the aggregated balance sheet total of the members of the consolidation group, according to their annual accounts. For the purposes of this calculation, undertakings in which a participation is held must be taken into account as regards the amount of their balance sheet total corresponding to the aggregated proportional share held by the consolidation group. However, where consolidated accounts are available, they must be used instead of aggregated accounts.

11/08/2004

Definition of financial conglomerate: solvency requirement

PRU 8.4.12

The solvency and capital adequacy requirements referred to in the financial conglomerate definition decision tree must be calculated in accordance with the provisions of the relevant sectoral rules.

11/08/2004

Definition of financial conglomerate: discretionary changes to the definition

PRU 8.4.13

Articles 3(3) to 3(6), Article 5(4) and Article 6(5) of the Financial Groups Directive allow competent authorities, on a case by case basis, to:

(1) change the definition of financial conglomerate and the obligations applying with respect to a financial conglomerate;
(2) apply the scheme in the Financial Groups Directive to EEA regulated entities in specified kinds of group structures that do not come within the definition of financial conglomerate; and
(3) exclude a particular entity in the scope of capital adequacy requirements that apply with respect to a financial conglomerate.

11/08/2004

Capital adequacy requirements: introduction

PRU 8.4.14

The capital adequacy provisions of PRU 8.4 are designed to be applied to EEA-based financial conglomerates.

11/08/2004

PRU 8.4.15

PRU 8.4.25 R is a high level capital adequacy rule. It applies whether or not the FSA is the coordinator of the financial conglomerate concerned.

11/08/2004

PRU 8.4.16

PRU 8.4.26 R to PRU 8.4.31 R and PRU 8 Ann 1R G implement the detailed capital adequacy requirements of the Financial Groups Directive. They only deal with a financial conglomerate for which the FSA is the coordinator. If another competent authority is coordinator of a financial conglomerate, those rules do not apply with respect to that financial conglomerate and instead that coordinator will be responsible for implementing those detailed requirements.

11/08/2004

PRU 8.4.17

Annex I of the Financial Groups Directive lays down four methods for calculating capital adequacy at the level of a financial conglomerate. Those four methods are implemented as follows:

(1) Method 1 calculates capital adequacy using accounting consolidation. It is implemented by PRU 8.4.29 R to PRU 8.4.31 R and Part 1 of PRU 8 Ann 1R G.
(2) Method 2 calculates capital adequacy using a deduction and aggregation approach. It is implemented by PRU 8.4.29 R to PRU 8.4.31 R and Part 2 of PRU 8 Ann 1R 1.
(3) Method 3 calculates capital adequacy using book values and the deduction of capital requirements. It is implemented by PRU 8.4.29 R to PRU 8.4.31 R and Part 3 of PRU 8 Ann 1R G.
(4) Method 4 consists of a combination of Methods 1, 2 and 3 from Annex I of the Financial Groups Directive, or a combination of two of those Methods. It is implemented by PRU 8.4.26 R to PRU 8.4.28 R, PRU 8.4.30 R and Part 4 of PRU 8 Ann 1R G.

11/08/2004

PRU 8.4.18

Part 4 of PRU 8 Ann 1R G (Use of Method 4 from Annex I of the Financial Conglomerates Directive) applies the FSA's sectoral rules with respect to the financial conglomerate as a whole, with some adjustments. Where Part 4 of PRU 8 Ann 1R G applies the FSA's sectoral rules for:

(1) the insurance sector, that involves a combination of Methods 2 and 3; and
(2) the banking sector and the investment services sector, that involves a combination of Methods 1 and 3.

11/08/2004

PRU 8.4.19

Paragraph 5.5 of PRU 8 Ann 1R G (Capital adequacy calculations for financial conglomerates) deals with a case in which there are no capital ties between entities in a financial conglomerate. In particular, the FSA, after consultation with the other relevant competent authorities and in accordance with Annex I of the Financial Groups Directive, will determine which proportional share of a solvency deficit in such an entity will have to be taken into account, bearing in mind the liability to which the existing relationship gives rise.

11/08/2004

PRU 8.4.20

(1) In the following cases, the FSA (acting as coordinator) may choose which of the four methods for calculating capital adequacy laid down in Annex I of the Financial Groups Directive should apply:

(a) where a financial conglomerate is headed by a regulated entity that has been authorised by the FSA; or
(b) the only relevant competent authority for the financial conglomerate is the FSA.

(2) PRU 8.4.28 R automatically applies Method 4 from Annex I of the Financial Groups Directive in these circumstances except in the cases set out in PRU 8.4.28 R (1)(e) and PRU 8.4.28 R (1)(f). The process in PRU 8.4.22 G does not apply.

11/08/2004

PRU 8.4.21

Where PRU 8.4.20 G does not apply, the Annex I method to be applied is decided by the coordinator after consultation with the relevant competent authorities and the financial conglomerate itself.

11/08/2004

PRU 8.4.22

The method of calculating capital adequacy chosen in respect of a financial conglomerate as described in PRU 8.4.21 G will be applied with respect to that financial conglomerate by varying the Part IV permission of a firm in that financial conglomerate to include a requirement. That requirement will have the effect of obliging the firm to ensure that the financial conglomerate has capital resources of the type and amount needed to comply with whichever of the methods in PRU 8 Ann 1R G is to be applied with respect to that financial conglomerate. The powers in the Act relating to waivers and varying a firm's Part IV permission can be used to implement one of the methods from Annex I of the Financial Groups Directive in a way that is different from that set out in PRU 8.4 and PRU 8 Ann 1R G if that is necessary to reflect the consultations referred to in PRU 8.4.21 G.

11/08/2004

PRU 8.4.23

If there is more than one firm in a financial conglomerate with a Part IV permission, the FSA would not normally expect to apply the requirement described in PRU 8.4.22 G to all of them. Normally it will only be necessary to apply it to one.

11/08/2004

PRU 8.4.24

The FSA expects that in all or most cases falling into PRU 8.4.21 G, the rules in Part 4 of PRU 8 Ann 1R G will be applied.

11/08/2004

Capital adequacy requirements: high level requirement

PRU 8.4.25

(1) A firm that is a member of a financial conglomerate must at all times have capital resources of such an amount and type that results in the capital resources of the financial conglomerate taken as a whole being adequate.
(2) This rule does not apply with respect to any financial conglomerate until notification has been made that it has been identified as a financial conglomerate as contemplated by Article 4(2) of the Financial Groups Directive.

01/01/2005

Capital adequacy requirements: application of Method 4 from Annex I of the Financial Groups Directive

PRU 8.4.26

If this rule applies under PRU 8.4.27 R to a firm with respect to a financial conglomerate of which it is a member, the firm must at all times have capital resources of an amount and type:

(1) that ensure that the financial conglomerate has capital resources of an amount and type that comply with the rules applicable with respect to that financial conglomerate under Part 4 of PRU 8 Ann 1R G (as modified by that annex); and
(2) that as a result ensure that the firm complies with those rules (as so modified) with respect to that financial conglomerate.

01/01/2005

PRU 8.4.27

PRU 8.4.26 R applies to a firm with respect to a financial conglomerate of which it is a member if one of the following conditions is satisfied:

(1) the condition in PRU 8.4.28 R is satisfied; or
(2) this rule is applied to the firm with respect to that financial conglomerate as described in PRU 8.4.30 R.

01/01/2005

Capital adequacy requirements: compulsory application of Method 4 from Annex I of the Financial Groups Directive

PRU 8.4.28

(1) The condition in this rule is satisfied for the purpose of PRU 8.4.27 R (1) with respect to a firm and a financial conglomerate of which it is a member (with the result that PRU 8.4.26 R automatically applies to that firm) if:

(a) notification has been made in accordance with regulation 2 of the Financial Groups Directive Regulations that the financial conglomerate is a financial conglomerate and that the FSA is coordinator of that financial conglomerate;
(b) the financial conglomerate is not part of a wider FSA regulated EEA financial conglomerate;
(c) the financial conglomerate is not an FSA regulated EEA financial conglomerate under another rule or under paragraph (b) of the definition of FSA regulated EEA financial conglomerate (application of supplementary supervision through a firm's Part IV permission);
(d) one of the following conditions is satisfied:

(i) the financial conglomerate is headed by a regulated entity that is a UK domestic firm; or
(ii) the only relevant competent authority for that financial conglomerate is the FSA;

(e) this rule is not disapplied under paragraph 5.5 of PRU 8 Ann 1R G (No capital ties); and
(f) the financial conglomerate meets the condition set out in the box titled Threshold Test 2 (10% average of balance sheet and solvency requirements) in the financial conglomerate definition decision tree.

(2) Once PRU 8.4.26 R applies to a firm with respect to a financial conglomerate of which it is a member under PRU 8.4.27 R (1), (1)(f) ceases to apply with respect to that financial conglomerate. Therefore the fact that the financial conglomerate subsequently ceases to meet the condition in (1)(f) does not mean that the condition in this rule is not satisfied.

01/01/2005

Capital adequacy requirements: application of Methods 1, 2 or 3 from Annex I of the Financial Groups Directive

PRU 8.4.29

If with respect to a firm and a financial conglomerate of which it is a member, this rule is applied to the firm with respect to that financial conglomerate as described in PRU 8.4.30 R, the firm must at all times have capital resources of an amount and type that ensures that the conglomerate capital resources of that financial conglomerate at all times equal or exceed its conglomerate capital resources requirement.

01/01/2005

Capital adequacy requirements: use of Part IV permission to apply Annex I of the Financial Groups Directive

PRU 8.4.30

With respect to a firm and a financial conglomerate of which it is a member:

(1) PRU 8.4.26 R (Method 4 from Annex I of the Financial Groups Directive) is applied to the firm with respect to that financial conglomerate for the purposes of PRU 8.4.27 R (2); or
(2) PRU 8.4.29 R (Methods 1 to 3 from Annex I of the Financial Groups Directive) is applied to the firm with respect to that financial conglomerate;

if the firm's Part IV permission contains a requirement obliging the firm to comply with PRU 8.4.26 R or, as the case may be, PRU 8.4.29 R.

01/01/2005

PRU 8.4.31

If PRU 8.4.29 R (Methods 1-3 from Annex I of the Financial Groups Directive) applies to a firm with respect to a financial conglomerate of which it is a member, the definitions of conglomerate capital resources and conglomerate capital resources requirement that apply for the purposes of that rule are the ones from whichever of Part 1, Part 2 or Part 3 of PRU 8 Ann 1R G is specified in the requirement referred to in PRU 8.4.30 R.

01/01/2005

Risk concentration and intra-group transactions: introduction

PRU 8.4.32

PRU 8.4.35 R implements Article 7(4) and Article 8(4) of the Financial Groups Directive, which provide that where a financial conglomerate is headed by a mixed financial holding company, the sectoral rules regarding risk concentration and intra-group transactions of the most important financial sector in the financial conglomerate, if any, shall apply to that sector as a whole, including the mixed financial holding company.

11/08/2004

PRU 8.4.33

Articles 7(3) (Risk concentration) and 8(3) (Intra-group transactions) and Annex II (Technical application of the provisions on intra-group transactions and risk concentration) of the Financial Groups Directive say that Member States may apply at the level of the financial conglomerate the provisions of the sectoral rules on risk concentrations and intra-group transactions. PRU 8.4 does not take up that option, although the FSA may impose such obligations on a case by case basis.

11/08/2004

Risk concentration and intra-group transactions: application

PRU 8.4.34

PRU 8.4.35 R applies to a firm with respect to a financial conglomerate of which it is a member if:

(1) the condition in Articles 7(4) and 8(4) of the Financial Groups Directive is satisfied (the financial conglomerate is headed by a mixed financial holding company); and
(2) that financial conglomerate is an FSA regulated EEA financial conglomerate.

01/01/2005

Risk concentration and intra group transactions: the main rule

PRU 8.4.35

A firm must ensure that the sectoral rules regarding risk concentration and intra-group transactions of the most important financial sector in the financial conglomerate referred to in PRU 8.4.34 R are complied with with respect to that financial sector as a whole, including the mixed financial holding company. The FSA's sectoral rules for these purposes are those identified in the table in PRU 8.4.36 R.

01/01/2005

Risk concentration and intra-group transactions: Table of applicable sectoral rules

PRU 8.4.36

Application of sectoral rules

This table belongs to PRU 8.4.35 R

The most important financial sector

Applicable sectoral rules

Risk concentration

Intra-group transactions

Banking sector

Rules 3.3.13, 3.3.19 and 3.3.21 of chapter GN of IPRU(BANK) (as they apply to large exposures on a consolidated basis)

Rules 3.3.13, 3.3.19 and 3.3.21 of chapter GN of IPRU(BANK) (as they apply to large exposures on a solo basis)

Insurance sector

None

Rule 9.39 of IPRU(INS)

Investment services sector

Rule 14.3.2 in Chapter 14 of IPRU(INV)

Rule 10-190 in Chapter 10 of IPRU(INV) as it applies on a solo basis

Note:

The rules as applied in column three apply without any concession or exemption for exposures to other group members.

Note

The decision tree in paragraph 4.5 of PRU 8 Ann 1R G applies for the purpose of identifying the most important financial sector.

01/01/2005

PRU 8.4.37

The material in IPRU(BANK) that has particular application to the rules in IPRU(BANK) referred to in the table in PRU 8.4.36 R is:

(1) (in the case of column 2) Chapter LE as it applies on a consolidated basis;
(2) (in the case of column 3) Chapter LE as it applies on a solo basis.

01/01/2005

PRU 8.4.38

The table in PRU 8.4.36 R does not refer to the rules for building societies as a building society cannot have a mixed financial holding company as a parent.

01/01/2005

The financial sectors: asset management companies

PRU 8.4.39

(1) In accordance with Article 30 of the Financial Groups Directive (Asset management companies), this rule deals with the inclusion of an asset management company that is a member of a financial conglomerate in the scope of regulation of financial conglomerates. This rule does not apply to the definition of financial conglomerate.
(2) An asset management company is in the overall financial sector and is a regulated entity for the purpose of:

(a) PRU 8.4.26 R to PRU 8.4.36 R;
(b) PRU 8 Ann 1R G (Capital adequacy calculations for financial conglomerates) and PRU 8 Ann 2R (Prudential rules for third country groups); and
(c) any other provision of the Handbook relating to the supervision of financial conglomerates.

(3) In the case of a financial conglomerate for which the FSA is the coordinator, all asset management companies must be allocated to one financial sector for the purposes in (2), being either the investment services sector or the insurance sector. But if that choice has not been made in accordance with (4) and notified to the FSA in accordance with (4)(d), an asset management company must be allocated to the investment services sector.
(4) The choice in (3):

(a) must be made by the undertaking in the financial conglomerate holding the position referred to in Article 4(2) of the Financial Groups Directive (group member to whom notice must be given that the group has been found to be a financial conglomerate);
(b) applies to all asset management companies that are members of the financial conglomerate from time to time;
(c) cannot be changed; and
(d) must be notified to the FSA as soon as reasonably practicable after the notification in (4)(a).

11/08/2004

PRU 8.5

Third-country groups

31/12/2004

Application

PRU 8.5.1

PRU 8.5 applies to every firm that is a member of a third-country group. But it does not apply to:

(1) an incoming EEA firm; or
(2) an incoming Treaty firm; or
(3) a UCITS qualifier; or
(4) an ICVC.

11/08/2004

Purpose

PRU 8.5.2

PRU 8.5 implements in part Article 18 of the Financial Groups Directive and Article 56a of the Banking Consolidation Directive.

11/08/2004

Equivalence

PRU 8.5.3

The first question that must be asked about a third-country financial group is whether the EEA regulated entities in that third-country group are subject to supervision by a third-country competent authority, which is equivalent to that provided for by the Financial Groups Directive (in the case of a financial conglomerate) or the EEA prudential sectoral legislation for the banking sector or the investment services sector (in the case of a banking and investment group). Article 18(1) of the Financial Groups Directive sets out the process for establishing equivalence with respect to third-country financial conglomerates and the first three paragraphs of Article 56a of the Banking Consolidation Directive does so with respect to third-country banking and investment groups.

11/08/2004

Other methods: General

PRU 8.5.4

If the supervision of a third-country group by a third-country competent authority does not meet the equivalence test referred to in PRU 8.5.3 G, competent authorities may apply other methods that ensure appropriate supervision of the EEA regulated entities in that third-country group in accordance with the aims of supplementary supervision under the Financial Groups Directive or consolidated supervision under the applicable EEA prudential sectoral legislation.

11/08/2004

Supervision by analogy: introduction

PRU 8.5.5

If the supervision of a third-country group by a third-country competent authority does not meet the equivalence test referred to in PRU 8.5.3 G, a competent authority may, rather than take the measures described in PRU 8.5.4 G, apply, by analogy, the provisions concerning supplementary supervision under the Financial Groups Directive or, as applicable, consolidated supervision under the applicable EEA prudential sectoral legislation, to the EEA regulated entities in the banking sector, investment services sector and (in the case of a financial conglomerate) insurance sector.

11/08/2004

PRU 8.5.6

The FSA believes that it will only be right to adopt the option in PRU 8.5.5 G in response to very unusual group structures.

11/08/2004

PRU 8.5.7

PRU 8.5.8 R and PRU 8.5.9 R and PRU 8 Ann 2R set out rules to deal with the situation covered in PRU 8.5.5 G. Those rules do not apply automatically. Instead, they can only be applied with respect to a particular third-country group through the Part IV permission of a firm in that third-country group. Broadly speaking the procedure described in PRU 8.4.22 G also applies to this process.

11/08/2004

Supervision by analogy: rules for third-country conglomerates

PRU 8.5.8

If the Part IV permission of a firm contains a requirement obliging it to comply with this rule with respect to a third-country financial conglomerate of which it is a member, it must comply, with respect to that third-country financial conglomerate, with the rules in Part 1 of PRU 8 Ann 2R, as adjusted by Part 3 of that annex.

01/01/2005

Supervision by analogy: rules for third-country banking and investment groups

PRU 8.5.9

If the Part IV permission of a firm contains a requirement obliging it to comply with this rule with respect to a third-country banking and investment group of which it is a member, it must comply, with respect to that third-country banking and investment group, with the rules in Part 2 of PRU 8 Ann 2R, as adjusted by Part 3 of that annex.

01/01/2005

PRU 8 Ann 1R

31/12/2004

Capital adequacy calculations for financial conglomerates (PRU 8.4.26 R and PRU 8.4.29 R)

31/12/2004

PRU 8 Ann 1R 1

Table: PART 1: Method of Annex I of the Financial Groups Directive (Accounting Consolidation Method)

Capital resources

1.1

The conglomerate capital resources of a financial conglomerate calculated in accordance with this Part are the capital of that financial conglomerate, calculated on an accounting consolidation basis, that qualifies under paragraph 1.2.

1.2

The elements of capital that qualify for the purposes of paragraph 1.1 are those that qualify in accordance with the applicable sectoral rules, in accordance with the following:

(1)

the conglomerate capital resources requirement is divided up in accordance with the contribution of each financial sector to it; and

(2)

the portion of the conglomerate capital resources requirement attributable to a particular financial sector must be met by capital resources that are eligible in accordance with the applicable sectoral rules for that financial sector.

Capital resources requirement

1.3

The conglomerate capital resources requirement of a financial conglomerate calculated in accordance with this Part is equal to the sum of the capital adequacy and solvency requirements for each financial sector calculated in accordance with the applicable sectoral rules for that financial sector.

Consolidation

1.4

The information required for the purpose of establishing whether or not a firm is complying with PRU 8.4.29 R (insofar as the definitions in this Part are applied for the purpose of that rule) must be based on the consolidated accounts of the financial conglomerate, together with such other sources of information as appropriate.

1.5

The applicable sectoral rules that are applied under this Part are the applicable sectoral consolidation rules. Other applicable sectoral rules must be applied if required.

31/12/2004

PRU 8 Ann 1R 2

Table: PART 2: Method 2 of Annex I of the Financial Groups Directive (Deduction and aggregation Method)

Capital resources

2.1

The conglomerate capital resources of a financial conglomerate calculated in accordance with this Part are equal to the sum of the following amounts (so far as they qualify under paragraph 2.3) for each member of the overall financial sector:

(1)

(for the person at the head of the financial conglomerate) its solo capital resources;

(2)

(for any other member):

(a)

its solo capital resources; less

(b)

the book value of the financial conglomerate's investment in that member.

2.2

The deduction in paragraph 2.1(2) must be carried out separately for each type of capital represented by the financial conglomerate's investment in the member concerned.

2.3

The elements of capital that qualify for the purposes of paragraph 2.1 are those that qualify in accordance with the applicable sectoral rules. In particular, the portion of the conglomerate capital resources requirement attributable to a particular member of a financial sector must be met by capital resources that would be eligible under the sectoral rules that apply to the calculation of its solo capital resources.

Capital resources requirement

2.4

The conglomerate capital resources requirement of a financial conglomerate calculated in accordance with this Part is equal to the sum of the solo capital resources requirement for each member of the financial conglomerate that is in the overall financial sector.

Partial inclusion

2.5

The capital resources and capital resources requirements of a member of the financial conglomerate in the overall financial sector must be included proportionally. If however the member is a subsidiary undertaking and it has a solvency deficit, they must be included in full.

Accounts

2.6

The information required for the purpose of establishing whether or not a firm is complying with PRU 8.4.29 R (insofar as the definitions in this Part are applied for the purpose of that rule) must be based on the individual accounts of members of the financial conglomerate, together with such other sources of information as appropriate.

31/12/2004

PRU 8 Ann 1R 3

Table: PART 3: Method 3 of Annex I of the Financial Groups Directive (Book value/Requirement Method)

Capital resources

3.1

The conglomerate capital resources of a financial conglomerate calculated in accordance with this Part are equal to the capital resources of the person at the head of the financial conglomerate that qualify under paragraph 3.2.

3.2

The elements of capital that qualify for the purposes of paragraph 3.1 are those that qualify in accordance with the applicable sectoral rules. In particular, the portion of the conglomerate capital resources requirement attributable to a particular member of a financial sector must be met by capital resources that would be eligible under the sectoral rules that apply to the calculation of its solo capital resources.

Capital resources requirement

3.3

The conglomerate capital resources requirement of a financial conglomerate calculated in accordance with this Part is equal to the sum of the following amounts for each member of the overall financial sector:

(1)

(in the case of the person at the head of the financial conglomerate) its solo capital resources requirement;

(2)

(in the case of any other member) the higher of the following two amounts:

(a)

its solo capital resources requirement; and

(b)

the book value of the interest of the person at the head of the financial conglomerate in that member.

3.4

A participation may be valued using the equity method of accounting.

Partial inclusion

3.5

The capital resources requirement of a member of the financial conglomerate in the overall financial sector must be included proportionally. If however the member has a solvency deficit and is a subsidiary undertaking, it must be included in full.

Accounts

3.6

The information required for the purpose of establishing whether or not a firm is complying with PRU 8.4.29 R (insofar as the definitions in this Part are applied for the purpose of that rule) must be based on the individual accounts of members of the financial conglomerate, together with such other sources of information as appropriate.

31/12/2004

PRU 8 Ann 1R 4

Table: PART 4: Method 4 of Annex I of the Financial Groups Directive (Combination of Methods 1, 2 and 3)

Applicable sectoral rules

4.1

The rules that apply with respect to a particular financial conglomerate under PRU 8.4.26 R are those relating to capital adequacy and solvency set out in the table in paragraph 4.2.

31/12/2004

PRU 8 Ann 1R 5

Table: Paragraph 4.2: Application of sectoral consolidation rules

Type of financial conglomerate

Applicable sectoral consolidation rules

Banking conglomerate

IPRU(BANK) Chapter GN rule 3.3.13 (as it applies on a consolidated basis), subject to paragraph 4.7.

Insurance conglomerate

PRU 8.3 amended in accordance with Part 5.

Building society conglomerate

IPRU(BSOC) (Volume 1) Chapter 1, rule 1.2.1 (as it applies on a consolidated basis).

Investment services conglomerate

Chapter 14 of IPRU(INV).

31/12/2004

PRU 8 Ann 1G 6

Table

How to apply chapter 14 of IPRU(INV)

4.3

Where chapter 14 of IPRU(INV) applies:

(1)

the main investment services undertaking is treated as being the main firm for the purpose of rule 14.4.2 of chapter 14 of IPRU(INV);

(2)

if the main investment services undertaking is not subject to any of the FSA's sectoral rules applied by chapter 14 of IPRU(INV), then the FSA's sectoral rules that are applied are those that would do so if:

(a)

it were a UK domestic firm; and

(b)

it had a permission that includes all the regulated activities that it would need to have in its Part IV permission if it carried on all its activities in the United Kingdom.

The different types of financial conglomerate

4.4

(1)

The decision tree in paragraph 4.5:

(a)

decides into which of the categories listed in the table in paragraph 4.2 a financial conglomerate falls; and

(b)

modifies the definition of the most important financial sector for the purposes of PRU 8 Ann 1R G and for the purposes of any other provision in PRU 8 (Group risk) that applies that decision tree.

(2)

Paragraph 6.1(2) (financial institution allocated to the banking sector) and paragraph 6.1(3) (allocation of asset management companies) apply for the purpose of 4.4 and the table in paragraph 4.5.

31/12/2004

PRU 8 Ann 1.7

Paragraph 4.5: Types of financial conglomerate and definition of most important financial sector

31/12/2004

PRU 8 Ann 1.8

Table *

A mixed financial holding company

4.6

A mixed financial holding company must be treated in the same way as:

(1)

a financial holding company (if the rules in IPRU(BANK) or IPRU(INV)) are applied; or

(2)

an insurance holding company (if the rules in PRU 8.3 are applied).

E-money

4.7

If there are no full credit institutions or investment firms in a banking conglomerate but there are one or more e-money issuers, the sectoral rules in IPRU(BANK) are amended as follows :

(1)

the rules in ELM that apply on a solo basis must be used to establish the capital requirement for the e-money issuers; and

(2)

for the purpose of (1), those rules in ELM shall be amended by calculating the amount of the deductions in respect of ownership shares and capital falling into ELM 2.4.17 R (6) in accordance with paragraph 3.3(2).

31/12/2004

PRU 8 Ann 1R 9

Table: PART 5: Principles applicable to all methods

Transferability of capital

5.1

Capital may not be included in:

(1)

a firm's conglomerate capital resources under PRU 8.4.29 R; or

(2)

in the capital resources of the financial conglomerate for the purposes of PRU 8.4.26 R;

if the effectiveness of the transferability and availability of the capital across the different members of the financial conglomerate is insufficient, given the objectives (as referred to in the third unnumbered sub-paragraph of paragraph 2(ii) of Annex I of the Financial Groups Directive (Technical principles)) of the capital adequacy rules for financial conglomerates.

Double counting

5.2

Capital must not be included in:

(1)

a firm's conglomerate capital resources under PRU 8.4.29 R; or

(2)

the capital resources of the financial conglomerate for the purposes of PRU 8.4.26 R;

if:

(3)

it would involve double counting or multiple use of the same capital; or

(4)

it results from any inappropriate intra-group creation of capital.

Cross sectoral capital

5.3

In accordance with the second sub-paragraph of paragraph 2(ii) of Section I of Annex I of the Financial Groups Directive (Other technical principles and insofar as not already required in Parts 1-3):

(1)

the solvency requirements for each different financial sector represented in a financial conglomerate required by PRU 8.4.26 R or, as the case may be, PRU 8.4.29 R must be covered by own funds elements in accordance with the corresponding applicable sectoral rules; and

(2)

if there is a deficit of own funds at the financial conglomerate level, only cross sectoral capital (as referred to in that sub-paragraph) shall qualify for verification of compliance with the additional solvency requirement required by PRU 8.4.26 R or, as the case may be, PRU 8.4.29 R.

Application of sectoral rules

5.4

The following adjustments apply to the applicable sectoral rules as they are applied by the rules in this annex.

(1)

The scope of those rules will be extended to cover any mixed financial holding company and each other member of the overall financial sector.

(2)

If any of those rules would otherwise not apply to a situation in which they are applied by PRU 8 Ann 1R G, those rules nevertheless still apply (and in particular, any of those rules that would otherwise have the effect of disapplying consolidated supervision (or, in the case of the insurance sector, supplementary supervision) do not apply).

(3)

(If it would not otherwise have been included) an ancillary investment services undertaking is included in the investment services sector.

(4)

(If it would not otherwise have been included) an ancillary insurance services undertaking is included in the insurance sector.

(5)

(In relation to the insurance sector) to the extent that:

(a)

those rules merely require a report on whether or not a specified level of solvency is met (a soft limit); or

(b)

the requirements in those rules concern having certain net assets of an amount at or above certain levels;

those requirements are restated so as to include an obligation at all times actually to have capital at or above that level (a hard limit), thereby turning a soft limit drafted by reference to assets and liabilities into a hard limit requiring capital to be held at or above specified levels. If those rules apply both a hard and a soft limit, and the level of the soft limit is higher, that soft limit is applied under this annex, but translated into a hard limit in accordance with the earlier provisions of (5).

(6)

The scope of the those rules is amended so as to remove restrictions relating to where members of the financial conglomerate are incorporated or have their head office, so that the scope covers every member of the financial conglomerate that would have been included in the scope of those rules if those members had their head offices in an EEA State.

(7)

(For the purposes of Parts 1 to 3) those rules must be adjusted, if necessary, when calculating the capital resources, capital resources requirements or solvency requirements for a particular financial sector to exclude those for a member of another financial sector.

No capital ties

5.5

(1)

This rule deals with a financial conglomerate in which some of the members are not linked by capital ties at the time of the notification referred to in PRU 8.4.28 R (1) (Capital adequacy requirements: Compulsory application of Method 4 from Annex I of the Financial Groups Directive).

(2)

If:

(a)

PRU 8.4.26 R (Capital adequacy requirements: Application of Method 4 from Annex I of the Financial Groups Directive) would otherwise apply with respect to a financial conglomerate under PRU 8.4.28 R; and

(b)

all members of that financial conglomerate are linked directly or indirectly with each other by capital ties except for members that collectively are of negligible interest with respect to the objectives of supplementary supervision of regulated entities in a financial conglomerate (the "peripheral members");

PRU 8.4.28 R continues to apply. Otherwise PRU 8.4.28 R does not apply with respect to a financial conglomerate falling into (1).

(3)

If PRU 8.4.28 R applies with respect to a financial conglomerate in accordance with (2) the peripheral members must be excluded from the calculations under PRU 8.4.26 R.

(4)

If:

(a)

PRU 8.4.26 R applies with respect to a financial conglomerate falling into (1) under PRU 8.4.27 R (2) (Use of Part IV permission to apply Annex I of the Financial Groups Directive); or

(b)

PRU 8.4.49 (Capital adequacy requirements: Application of Methods 1, 2 or 3 from Annex I of the Financial Groups Directive) applies with respect to a financial conglomerate falling into (1);

then:

(c)

the treatment of the links in (1) (including the treatment of any solvency deficit) is as provided for in the requirement referred to in PRU 8.4.30 R; and

(d)

PRU 8.4.26 R or PRU 8.4.29 R, as the case may be, apply even if the applicable sectoral rules do not deal with how undertakings not linked by capital ties are to be dealt with for the purposes of consolidated supervision (or, in the case of the insurance sector, supplementary supervision).

(5)

Once PRU 8.4.26 R applies to a firm with respect to a financial conglomerate of which it is a member under PRU 8.4.27 R (1) (automatic application of Method 4 from Annex I of the Financial Groups Directive on satisfaction of the condition in PRU 8.4.28 R), the disapplication of PRU 8.4.28 R under (2) ceases to apply with respect to that financial conglomerate.

31/12/2004

PRU 8 Ann 1R 10

Table: PART 6: Definitions used in this Annex

Defining the financial sectors

6.1

For the purposes of Parts 1 to 3 of this annex (but, unless specified otherwise in paragraph 4.4, not for the purposes of the definition of most important financial sector):

(1)

the banking sector and the investment services sector are considered separately;

(2)

if a financial institution could otherwise fall into both the banking sector and the investment services sector, it must be allocated to the banking sector;

(3)

an asset management company is allocated in accordance with PRU 8.4.39 R; and

(4)

a mixed financial holding company must be treated as being a member of the most important financial sector.

Solo capital resources requirement: UK domestic firms

6.2

The solo capital resources requirement for a regulated entity that is a UK domestic firm is its solo regulatory capital requirement under the FSA's sectoral rules for its financial sector applicable to it.

Solo capital resources requirement: EEA firms

6.3

The solo capital resources requirement for an EEA regulated entity that is subject to the solo capital adequacy sectoral rules for its financial sector of the competent authority that authorised it is equal to the amount of capital resources it is obliged to hold under those sectoral rules.

Solo capital resources requirement: mixed financial holding company

6.4

The solo capital resources requirement for a mixed financial holding company is a notional capital requirement. It is the capital adequacy requirement that applies to regulated entities in the most important financial sector under the table in paragraph 6.8.

Solo capital resources requirement: non-EEA firms subject to equivalent regimes

6.5

The solo capital resources requirement for a regulated entity that:

(1)

does not fall into paragraphs 6.2 to 6.4;

(2)

is subject to any of the sectoral rules referred to in paragraph 6.6 applicable to its financial sector; and

(3)

is incorporated in and has its head office in:

(a)

(where the sectoral rules in (2) are for the banking sector or the investment services sector) the same state or territory as the regulator for those sectoral rules, as referred to in paragraph 6.6(1) or 6.6(2)); or

(b)

(where the sectoral rules in (2) are for the insurance sector) the designated state or territory in question, as referred to in 6.6(3);

is equal to the amount of capital resources it is obliged to hold under those sectoral rules. However, where 3(b) would otherwise apply, paragraph 6.7 may be applied instead.

6.6

The sectoral rules referred to in paragraph 6.5 are:

(1)

(for the banking sector) the sectoral rules of or administered by one of the regulators listed in Appendix D of chapter CS of IPRU(BANK);

(2)

(for the investment services sector) the sectoral rules of or administered by one of the regulators listed in Appendix 59 of chapter 10 of IPRU(INV); and

(3)

(for the insurance sector) the sectoral rules of the designated States or territories excluding EEA States.

Solo capital resources requirement: other members

6.7

The solo capital resources requirement for any member of a financial conglomerate in the overall financial sector not treated under paragraphs 6.2 to 6.6 is a notional capital requirement. It is the capital resources requirement that would apply to it under the following rules:

(1)

(in the case of an asset management company) the rules in Chapter 7 of IPRU(INV); and

31/12/2004
Future version of PRU 8 Ann 1R 10 after 01/06/2005

PRU 8 Ann 1R 11

Table: Paragraph 6.8: The FSA's sectoral rules for the solo capital resources requirement

Financial sector

FSA's sectoral rules

Banking sector

The FSA's sectoral rules for banks, except that e-money issuers are subject to ELM.

Insurance sector

The FSA's sectoral rules for insurance undertakings.

Investment services sector

(1) The rules in IPRU(INV) that would apply on the assumptions in paragraph 4.3(2).

(2) (If (1) does not result in the application of any rules in IPRU(INV)) the rules in IPRU(INV) that would be applied to it under rule 14.5.2 of Chapter 14 of IPRU(INV) (Group financial resources requirement).

31/12/2004

PRU 8 Ann 1R 12

Table

Solo capital resources requirement: the insurance sector

6.9

References to capital requirements in the provisions of PRU 8 Ann 1R G defining solo capital resources requirement must be interpreted in accordance with paragraph 5.4(5).

Applicable sectoral consolidation rules

6.10

The applicable sectoral consolidation rules for a financial sector are the FSA's sectoral rules about capital adequacy and solvency on a consolidated basis that are applied in the table in paragraph 6.11.

31/12/2004

PRU 8 Ann 1R 13

Table: Paragraph 6.11: Application of sectoral consolidation rules

Financial sector

Type of financial conglomerate

FSA's sectoral rules

Banking sector

Building society conglomerate

The rules for building societies.

Any other type

The rules for banks.

Insurance sector

N/A

The rules for insurance undertakings.

Investment services sector

N/A

The rules for investment firms.

Note 1: Paragraph 4.6 applies for the purposes of those rules.

31/12/2004

PRU 8 Ann 1R 14

Table:

Applicable sectoral consolidation rules (contd.)

6.12

The rules referred to in the third column of the table in paragraph 6.11 are as follows:

(1)

the rules for building societies are the ones for building society conglomerates listed in the table in paragraph 4.2;

(2)

the rules for banks are the ones for banking conglomerates listed in the table in paragraph 4.2 as adjusted under paragraph 4.7;

(3)

the rules for insurance undertakings are whichever of the ones for insurance conglomerates that are applied by the table in paragraph 4.2; and

(4)

the rules for investment firms are the ones for investment services conglomerates listed in the table in paragraph 4.2 as applied under paragraph 4.3 (How to apply chapter 14 of IPRU(INV)).

31/12/2004

PRU 8 Ann 2R

01/12/2004

Prudential rules for third country groups (PRU 8.5.8 R to PRU 8.5.9 R)

11/08/2004

PRU 8 Ann 2R 1

Table: PART 1: Third-country financial conglomerates

1.1

This Part of this annex sets out the rules with which a firm must comply under PRU 8.5.8 R with respect to a financial conglomerate of which it is a member.

1.2

A firm must comply, with respect to the financial conglomerate referred to in paragraph 1.1, with whichever of PRU 8.4.26 R and PRU 8.4.29 R is applied under paragraph 1.3.

1.3

For the purposes of paragraph 1.2:

(1) the rule in PRU 8.4 that applies as referred to in paragraph 1.2 is the one that is specified by the requirement referred to in PRU 8.5.8 R;
(2) (where PRU 8.4.29 R is applied) the definitions of conglomerate capital resources and conglomerate capital resources requirement that apply for the purposes of that rule are the ones from whichever of Part 1, Part 2 or Part 3 of PRU 8 Ann 1R G is specified in that requirement; and
(3) the rules so applied (including those in PRU 8 Ann 1R G) are adjusted in accordance with paragraph 3.1.

1.4

If the condition in Articles 7(4) and 8(4) of the Financial Groups Directive is satisfied (the financial conglomerate is headed by a mixed financial holding company) with respect to the financial conglomerate referred to in paragraph 1.1 the firm must also comply with PRU 8.4.35 R (as adjusted in accordance with paragraph 3.1) with respect to that financial conglomerate.

1.5

A firm must comply with the following with respect to the financial conglomerate referred to in paragraph 1.1:

(1) PRU 8.1 (as it applies to financial conglomerates and as adjusted under paragraph 3.1); and
(2) PRU 8.4.25 R.

11/08/2004

PRU 8 Ann 2R 2

Table: PART 2: Third-country banking and investment groups

2.1

This Part of this annex sets out the rules with which a firm must comply under PRU 8.5.9 R with respect to a third-country banking and investment group of which it is a member.

2.2

A firm must comply with one of the sets of rules specified in paragraph 2.3 as adjusted under paragraph 3.1 with respect to the third-country banking and investment group referred to in paragraph 2.1.

2.3

The rules referred to in paragraph 2.2 are as follows:

(1) the applicable sectoral consolidation rules in IPRU(BANK); or
(2) the applicable sectoral consolidation rules for the investment services sector; or
(3) the rules in ELM 7.

2.4

The set of rules from paragraph 2.3 that apply with respect to a particular third-country banking and investment group (as referred to in paragraph 2.1) are those that would apply if they were adjusted in accordance with paragraph 3.1.

2.5

The sectoral rules applied by Part 2 of this annex cover all prudential rules applying on a consolidated basis including those relating to large exposures.

2.6

A firm must comply with PRU 8.1 (as it applies to banking and investment groups and as adjusted under paragraph 3.1) with respect to the third-country banking and investment group referred to in paragraph 2.1.

11/08/2004

PRU 8 Ann 2R 3

PART 3: Adjustment of scope

3.1

The adjustments that must be carried out under this paragraph are that the scope of the rules referred in Part 1 or Part 2 of this annex, as the case may be, are amended:

(1) so as to remove any provisions disapplying those rules for third-country groups;
(2) so as to remove all limitations relating to where a member of the third-country group is incorporated or has its head office; and
(3) so that the scope covers every member of the third-country group that would have been included in the scope of those rules if those members had their head offices in, and were incorporated in, an EEA State.

11/08/2004

PRU 8 Ann 3G

Guidance Notes for Classification of Groups

01/12/2004

This annex consists only of one or more forms or templates. Forms and templates are to be found through the 'Forms' link under Useful Links section at www.fsahandbook.info or on the Handbook CD-ROM.

Purpose and scope

11/08/2004

The form is designed to identify groups and sub-groups that are likely to be financial conglomerates under the Financial Groups Directive. A group may be a financial conglomerate if it contains both insurance and banking/investment businesses and meets certain threshold tests. The FSA needs to identify conglomerates with their head offices in the EEA and those with their head offices outside the EEA, although this does not necessarily mean that the latter will be subject to EEA conglomerate supervision.

11/08/2004

This form's purpose is to enable the FSA to obtain sufficient information so as to be able to determine how likely a group/sub-group is to be a financial conglomerate. In certain cases this can only be determined after consultation with the other EU relevant competent authorities. A second purpose of the form is therefore to identify any groups and sub-groups that may need such consultation so that this can be made as soon as possible. This should allow firms time to prepare to comply.

11/08/2004

The third purpose of the form is to gain information from firms on the most efficient way to implement the threshold calculations in detail (consistently with the directive). We have, therefore, asked for some additional information in part 4 of the form.

11/08/2004

A copy of this form can be found on the FSA's Financial Groups Website with current contact details.

11/08/2004

Please include workings showing the method employed to determine the percentages in part 2 (for the threshold conditions) and giving details of all important assumptions / approximations made in doing the calculations.

11/08/2004

The definition of financial conglomerate includes not only conventional groups made up of parent-subsidiary relationships but groups linked by control and "consolidation Article 12(1) relationships". If this is the case for your group, please submit along with this form a statement that this is the case. Please include in that statement an explanation of how you have included group members not linked by capital ties in the questionnaire calculations.

11/08/2004

A consolidation Article 12(1) relationship arises between undertakings in the circumstances set out in Article 12(1) of the Seventh Company Law Directive. These are set out in the Handbook Glossary (in the definition of consolidation Article 12(1) relationship). Broadly speaking, undertakings come within this definition if they do not form a conventional group but:

(a) are managed on a unified basis; or
(b) have common management.

11/08/2004

General guidance

11/08/2004

We would like this to be completed based on the most senior parent in the group, and, if applicable, for the company heading the most senior conglomerate group in the EEA. If appropriate, please also attach a list of all other likely conglomerate sub-groups.

11/08/2004

Please use the most recent accounts for the top level company in the group together with the corresponding accounts for all subsidiaries and participations that are included in the consolidated accounts. Please indicate the names of any significant subsidiaries with a different year-end from the group's year-end.

11/08/2004

Please note the following:

(a) Branches should be included as part of the parent entity.
(b) Include in the calculations overseas entities owned by the relevant group or sub-group.
(c) There are only two sectors for this purpose: banking/investment and insurance.
(d) You will need to assign non-regulated financial entities to one of these sectors:

• banking/investment activities are listed in - IPRU Banks CS 10 Appendix A
• insurance activities are listed in - IPRU Insurers Annex 11.1 and 11.2 p 163-168.
• Any operator of a UCITS scheme, insurance intermediary, mortgage broker and mixed financial holding company does not fall into the directive definitions of either financial sector or insurance sector.

They should therefore be ignored for the purposes of these calculations.

11/08/2004

Threshold tests

11/08/2004

For the purpose of completing section 2 of the form relating to the threshold tests, the following guidance should be used. However, if you consider that for your group there is a more appropriate calculation then you may use this calculation so long as the method of computation is submitted with the form.

11/08/2004

Calculating balance sheet totals

11/08/2004

Generally, use total (gross) assets for the balance sheet total of a group/entity. However, investments in other entities that are part of the group will need to be deducted from the sector that has made the investment and the balance sheet total of the entity is added to the sector in which it operates.

11/08/2004

Our expectation of how this may be achieved efficiently is as follows:

(i) Off-balance-sheet items should be excluded.
(ii) Where off-balance sheet treatment of funds under management and on-balance sheet treatment of policy holders' funds may distort the threshold calculation, groups should consult the FSA on the appropriateness of using other measures under article 3.5 of the Financial Groups Directive.
(iii) If consolidated accounts exist for a sub-group consisting of financial entities from only one of the two sectors, these consolidated accounts should be used to measure the balance-sheet total of the sub-group (i.e. total assets less investments in entities in the other sector). If consolidated accounts do not exist, intra-group balances should be netted out when calculating the balance sheet total of a single sector (but cross-sector intra-group balances should not be netted out).
(iv) Where consolidated accounts are used, minority interests should be excluded and goodwill should be included.
(v) Where accounting standards differ between entities, groups should consult the FSA if they believe this is likely materially to affect the threshold calculation.
(vi) Where there is a subsidiary or participation in the opposite sector from its parent (i.e. insurance sector for a banking/investment firm parent and vice versa), the balance sheet amount of the subsidiary or participation should be allocated to its sector using its individual accounts.
(vii) The balance-sheet total of the parent entity/sub-group is measured as total assets of the parent/sub-group less the book value of its subsidiaries or participations in the other sector (i.e. the value of the subsidiary or participation in the parent's consolidated accounts is deducted from the parent's consolidated assets).
(viii) The cross-sector subsidiaries or participations referred to above, valued according to their own accounts, are allocated pro-rata, according to the aggregated share owned by the parent/sub-group, to their own sector.
(ix) If the cross-sector entities above themselves own group entities in the first sector (i.e. that of the top parent/sub-group) these should (in accordance with the methods above) be excluded from the second sector and added to the first sector using individual accounts.

11/08/2004

Solvency (capital adequacy) requirements

11/08/2004

Generally, the solvency requirements should be according to sectoral rules (that is EEA prudential sectoral legislation - see Glossary). However, for convenience, you may choose to use either EEA rules, FSA rules or local rules. But if this choice makes a significant difference, either with respect to whether the group is a financial conglomerate or with respect to which sector is the biggest, you should consult with the FSA. Non-regulated financial entities should have proxy requirements calculated on the basis of the most appropriate sector. If sub-groups submit single sector consolidated returns then the solvency requirement may be taken from those returns.

11/08/2004

Our expectation of how this may be achieved efficiently is as follows:

(i) If you complete a solvency return for a sub-group consisting of financial entities from only one of the two sectors, the total solvency requirement for the sub-group should be used.
(ii) Solvency requirements taken must include any deductions from available capital so as to allow the appropriate aggregation of requirements.
(iii) Where there is a regulated subsidiary or participation in the opposite sector from its parent/sub-group, the solvency requirement of the subsidiary or participation should be from its individual regulatory return. If there is an identifiable contribution to the parent's solvency requirement in respect of the cross-sector subsidiary or participation, the parent's solvency requirement may be adjusted to exclude this.
(iv) Where there is an unregulated financial undertaking in the opposite sector from its parent/sub-group, the solvency requirement of the subsidiary or participation should be one of the following:

(a) (a) as if the entity were regulated by the FSA under the appropriate sectoral rules;
(b) (b) using EU minimum requirements for the appropriate sector; or
(c) (c) using non-EU local requirements* for the appropriate sector.

Please note on the form which of these options you have used, according to the country and sector, and whether this is the same treatment as in your latest overall group solvency calculation.
(v) For banking/investment requirements, use the total amount of capital required.
(vi) For insurance requirements, use the Required Minimum Margin:

(a) (a) UK firms, Form 9: for general insurance business = capital resources requirement [line 29]; for long-term insurance business = capital resources requirement (higher of Minimum Capital Requirement and Enhanced Capital Resources Requirement) [line 52].
(b) (b) Overseas firms, either:

• the local requirement*;• the EU minimum; or• the FSA requirement.* N.B. local requirements may only be used if they are at least equivalent to the EU minimum (designated states or territories). However, local requirements of a non-designated state or territory may be used if the resulting ratio in F5 is significantly below the 10% threshold (for this purpose "significantly below" may be taken to mean <5%).

11/08/2004

Market share measures

11/08/2004

These are not defined by the directive. The aim is to identify any standard industry approaches to measuring market share in individual EU countries by sector, or any data sources which are commonly used as a proxy.

11/08/2004

Threshold tests

11/08/2004

Test F2

11/08/2004

Test F3/F4/F5

11/08/2004

The relevant percentage for the insurance sector is:

11/08/2004

(A% + C%)/2 = I %

11/08/2004

The relevant percentage for the banking/investment sector is:

11/08/2004

(B% + D%)/2 = BI %

11/08/2004

The smallest sector is the sector with the smallest relevant percentage.

11/08/2004

If I% < BI% then F3 is insurance, F4 = A%, and F5 = C%

11/08/2004

If BI% < I% then F3 is banking/investment, F4 = B% and F5 = D

11/08/2004

PRU 8 Ann 4R

PRU 8 Ann 4 (see PRU 8.4.5 R)

01/12/2004

PRU 8 Ann 4.1R

11/08/2004

Footnote: The conditions are that the EEA regulated entity at the head of the consolidation group:

(1)is a parent undertaking of a member of the consolidation group in the overall financial sector;(2)has a participation in a member of the consolidation group that is in the overall financial sector; or(3)has a consolidation Article 12(1) relationship with a member of the consolidation group that is in the overall financial sector.

11/08/2004

Export chapter as

Legal Instruments that change this Chapter Group risk

PRU 9

Insurance
mediation & mortgage mediation, lending and administration

PRU 9.1

Responsibility for insurance mediation activity

01/12/2004

Application

PRU 9.1.1

This section applies to a firm with Part IV permission to carry on insurance mediation activity.

31/10/2004

Purpose

PRU 9.1.2

The main purpose of PRU 9.1.3 R, PRU 9.1.8 R and PRU 9.1.10 R is to implement in part the provisions of the Insurance Mediation Directive as these apply to firms regulated by the FSA.

31/10/2004

Responsibility for insurance mediation activity

PRU 9.1.3

An insurance intermediary, other than a sole trader, must allocate the responsibility for the firm's insurance mediation activity to a director or senior manager.

31/10/2004

PRU 9.1.4

The firm may allocate the responsibility for its insurance mediation activity under PRU 9.1.3 R to an approved person (or persons) performing:

(1) a governing function (other than the non-executive director function); or
(2) the apportionment and oversight function; or
(3) the significant management (other business operations) function.

14/01/2005
Past version of PRU 9.1.4 before 14/01/2005

PRU 9.1.5

(1) Typically an insurance intermediary will appoint a person performing a governing function (other than the non-executive director function) to direct its insurance mediation activity. Where this responsibility is allocated to a person performing another function, the person performing the apportionment and oversight function with responsibility for the apportionment of responsibilities under SYSC 2.1.1 R must ensure that the firm's insurance mediation activity under PRU 9.1.3 R is appropriately allocated.
(2) The descriptions of significant influence functions, other than the required functions, do not extend to activities carried on by an insurance intermediary with permission only to carry on insurance mediation activity and whose principal purpose is to carry on activities other than regulated activities (see SUP 10.1.21 R). In this case, the firm may allocate the responsibility for the firm's insurance mediation activity under PRU 9.1.3 R to one or more of the persons performing the apportionment and oversight function who will be required to be an approved person.
(3) In the case of a sole trader, the sole trader will be responsible for the firm's insurance mediation activity, whether or not he is himself a person approved to perform the sole trader function.

14/01/2005
Past version of PRU 9.1.5 before 14/01/2005

PRU 9.1.6

Where a firm has appointed an appointed representative to carry on insurance mediation activity on its behalf, the person responsible for the firm's insurance mediation activity will also be responsible for the insurance mediation activity carried on by an appointed representative.

31/10/2004

PRU 9.1.7

The FSA will specify in the FSA Register the name of the persons to whom the responsibility for the firm's insurance mediation activity has been allocated under PRU 9.1.3 R by inserting after the relevant controlled function the words "(insurance mediation)". In the case of a sole trader, the FSA will specify in the FSA Register the name of the sole trader as the 'contact person' in the firm.

14/01/2005
Past version of PRU 9.1.7 before 14/01/2005

Knowledge, ability and good repute

PRU 9.1.8

An insurance intermediary must establish on reasonable grounds that:

(1) a reasonable proportion of the persons within its management structure who are responsible for insurance mediation activity; and
(2) all other persons directly involved in its insurance mediation activity;

demonstrate the knowledge and ability necessary for the performance of their duties; and

(3) all the persons in its management structure and any staff directly involved in insurance mediation activity are of good repute.

31/10/2004

PRU 9.1.9

In determining a person's knowledge and ability under PRU 9.1.8 R (1) and PRU 9.1.8 R (2), the firm should have regard to matters including, but not limited to, whether the person:

(1) has demonstrated by experience and training to be able, or that he will be able, to perform his duties related to the firm's insurance mediation activity; and
(2) satisfies the relevant requirements of the FSA's Training and Competence sourcebook (TC).

31/10/2004

PRU 9.1.10

In considering a person's repute under PRU 9.1.8 R (3), the firm must ensure that the person:

(1) has not been convicted of any serious criminal offences linked to crimes against property or other crimes related to financial activities (other than spent convictions under the Rehabilitation of Offenders Act 1974 or any other national equivalent); and
(2) has not been adjudged bankrupt (unless the bankruptcy has been discharged);

under the law of any part of the United Kingdom or under the law of a country or territory outside the United Kingdom.

31/10/2004

PRU 9.1.11

For the purposes of PRU 9.1.10 R (1), the firm should give particular consideration to offences of dishonesty, fraud, financial crime or other offences under legislation relating to banking and financial services, companies, insurance and consumer protection.

31/10/2004

PRU 9.1.12

Firms are reminded that Principle 3 requires firms to take reasonable care to organise and control their affairs responsibly and effectively. Principle 3 is amplified in SYSC 3.1.1 R which requires firms to take reasonable care to establish and maintain such systems and controls as are appropriate to its business. A firm's systems and controls should enable it to satisfy itself of the suitability of anyone who acts for it (SYSC 3.2.13 G). This includes the assessment of an individual's honesty and competence. In addition, TC lists some general, high level commitments to training and competence which every firm should make and fulfil.

31/10/2004

PRU 9.1.13

PRU 9 Ann 1 G gives an example of how the FSA would expect firms to comply with the requirements in PRU 9.1.3 R, PRU 9.1.4 R, PRU 9.1.8 R and PRU 9.1.10 R.

31/10/2004

PRU 9.2

Professional indemnity insurance requirements for insurance and mortgage mediation activities

01/12/2004

Application

PRU 9.2.1

(1) This section applies to a firm with Part IV permission to carry on any of the activities in (2) unless (3), (4), (5) or (6) applies.
(2) The activities are:

(a) insurance mediation activity;
(b) mortgage mediation activity.

(a) In relation to insurance mediation activity, this section does not apply to a firm if another authorised person which has net tangible assets of more than ?10 million provides a comparable guarantee.
(b) If the firm is a member of a group in which there is an authorised person with net tangible assets of more than ?10 million, the comparable guarantee must be from that person.
(c) A 'comparable guarantee' means a written agreement on terms at least equal to those in PRU 9.2.10 R to finance the claims that might arise as a result of a breach by the firm of its duties under the regulatory system or civil law.

(4) In relation to mortgage mediation activity, this section does not apply to a firm if:

(a) it has net tangible assets of more than ?1 million; or
(b) the comparable guarantee provisions of (3) apply (as if the firm was carrying on insurance mediation activity) but substituting ?1 million for ?10 million in (a) and (b).

(5) In relation to all the activities in (2), this section does not apply to:

(a) an insurer; or
(b) a managing agent; or
(c) a firm to which IPRU(INV) 13.1.4(1) (Financial resource requirements for personal investment firms: requirement to hold professional indemnity insurance) applies.

(6) In relation to mortgage mediation activity, this section does not apply to an authorised professional firm:

(a) which is subject to IPRU(INV) 2.3.1 (Professional indemnity insurance requirements for authorised professional firms); and
(b) whose mortgage mediation activity is incidental to its main business.

31/10/2004

PRU 9.2.2

The definition of insurance mediation activity is any of several activities 'in relation to a contract of insurance' which includes a contract of reinsurance. This section, therefore, applies to a reinsurance intermediary in the same way as it applies to any other insurance intermediary.

31/10/2004

Purpose

PRU 9.2.3

The purposes of this section are to:

(1) implement article 4.3 of the Insurance Mediation Directive in so far as it requires insurance intermediaries to hold professional indemnity insurance, or some other comparable guarantee, against any liability that might arise from professional negligence; and
(2) meet the regulatory objectives of consumer protection and maintaining market confidence by ensuring that firms have adequate resources to protect themselves, and their customers, against losses arising from breaches in its duties under the regulatory system or civil law.

31/10/2004

PRU 9.2.4

Any breach in the duty of a firm or of its agents under the regulatory system or civil law can give rise to claims being made against the firm. Professional indemnity insurance has an important role to play in helping to finance such claims. In so doing, this section amplifies threshold condition 4 (Adequate resources). This threshold condition provides that a firm must have, on a continuing basis, resources that are, in the opinion of the FSA, adequate in relation to the regulated activities that the firm carries on.

31/10/2004

PRU 9.2.5

Under Principles 3 and 4 a firm is required to take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems and to maintain adequate financial resources. Under Principle 9 a firm is obliged to take reasonable care to ensure the suitability of its advice on investments and discretionary decisions for any customer who is entitled to rely upon its judgement.

31/10/2004

PRU 9.2.6

Although financial resources and appropriate systems and controls can generally mitigate operational risk, professional indemnity insurance has a role in mitigating the risks a firm faces in its day to day operations, including those arising from not meeting the legally required standard of care when advising on investments. The purpose of this section is to ensure that a firm has in place the type, and level, of professional indemnity insurance necessary to mitigate these risks.

31/10/2004

Requirement to hold professional indemnity insurance

PRU 9.2.7

A firm must take out and maintain professional indemnity insurance that is at least equal to the requirements of PRU 9.2.10 R from:

(1) an insurance undertaking authorised to transact professional indemnity insurance in the EEA; or
(2) a person of equivalent status in:

(i) a Zone A country; or
(ii) the Channel Islands, Gibraltar, Bermuda or the Isle of Man.

31/10/2004

PRU 9.2.8

The minimum limits of indemnity for a firm whose Part IV permission covers more than one regulated activity within the scope of this section is the higher of the limits of indemnity as set out in PRU 9.2.13 R and the limits of indemnity as set out in PRU 9.2.15 R. If the firm opts for a single comparable guarantee to finance the claims which might arise as a result of both activities, the provisions set out in PRU 9.2.1 R (3) apply.

14/01/2005
Past version of PRU 9.2.8 before 14/01/2005

PRU 9.2.9

A non-EEA firm (such as a captive insurance company outside the EEA) will be able to provide professional indemnity insurance only if it is authorised to do so in one of the countries or territories referred to in PRU 9.2.7 R (2). The purpose of this provision is to balance the level of protection required for the policyholder against a reasonable level of flexibility for the firm.

31/10/2004

Terms to be incorporated in the insurance

PRU 9.2.10

In relation to the activities referred to in PRU 9.2.1 R (2), the contract of professional indemnity insurance must incorporate terms which make provision for:

(1) cover in respect of claims for which a firm may be liable as a result of the conduct of itself, its employees and its appointed representatives (acting within the scope of their appointment);
(2) the minimum limits of indemnity as set out in PRU 9.2.13 R (in relation to insurance mediation activity) and PRU 9.2.15 R (in relation to mortgage mediation activity);
(3) an excess as set out in PRU 9.2.17 R to PRU 9.2.22 R;
(4) appropriate cover in respect of legal defence costs;
(5) continuous cover in respect of claims arising from work carried out from the date on which the firm was given Part IV permission in relation to any of the activities referred to in (2); and
(6) cover in respect of Ombudsman awards made against the firm.

31/10/2004

PRU 9.2.11

In relation to PRU 9.2.10 R (1), a firm should be aware that it is responsible for the conduct of all of its employees. The firm's employees include, but are not limited to, its partners, directors, individuals that are self-employed or operating under a contract hire agreement and any other individual that is employed in connection with its business.

31/10/2004

PRU 9.2.12

In relation to PRU 9.2.10 R (1), a firm should be aware that it is responsible for the conduct of all of its appointed representatives.

31/10/2004

Minimum limits of indemnity: insurance intermediary

PRU 9.2.13

If the firm is an insurance intermediary, then the minimum limits of indemnity referred to in PRU 9.2.10 R (2) are:

(1) for a single claim, ?1 million; and
(2) in aggregate, ?1.5 million or, if higher, 10% of annual income (see PRU 9.3.42 R) up to ?30 million.

14/01/2005
Past version of PRU 9.2.13 before 14/01/2005

PRU 9.2.14

If a policy is denominated in any currency other than euros, a firm must take reasonable steps to ensure that the limits of indemnity are, when the policy is effected and at renewal, at least equivalent to those required in PRU 9.2.13 R.

31/10/2004

Minimum limits of indemnity: mortgage intermediary

PRU 9.2.15

If the firm is a mortgage intermediary, then the minimum limit of indemnity referred to in PRU 9.2.10 R (2) is the higher of 10% of annual income (see PRU 9.3.42 R) up to ?1 million, and:

(1) for a single claim, ?100,000; or
(2) in aggregate, ?500,000.

14/01/2005
Past version of PRU 9.2.15 before 14/01/2005

Excess

PRU 9.2.16

In this section, "client assets" includes a document only if it has value, or is capable of having value, in itself (such as a bearer instrument).

31/10/2004

PRU 9.2.17

For a firm which does not hold client money or other client assets, the excess referred to in PRU 9.2.10 R (3) is not more than the higher of:

(1) ?2,500; and
(2) 1.5% of annual income (see PRU 9.3.42 R).

31/10/2004

PRU 9.2.18

For a firm which holds client money or other client assets, the excess referred to in PRU 9.2.10 R (3) is not more than the higher of:

(1) ?5,000; and
(2) 3% of annual income (see PRU 9.3.42 R).

31/10/2004

Policies covering more than one firm

PRU 9.2.19

If a policy provides cover to more than one firm, then in relation to PRU 9.2.13 R, PRU 9.2.14 R and PRU 9.2.15 R:

(1) the limits of indemnity must be calculated on the combined annual income (see PRU 9.3.42 R) of all the firms named in the policy; and
(2) each firm named in the policy must have the benefit of the minimum limits of indemnity as required in PRU 9.2.13 R or PRU 9.2.15 R.

31/10/2004

Additional capital

PRU 9.2.20

If a firm seeks to have an excess which is higher than the limits in PRU 9.2.17 R (for a firm not holding client money or other client assets) or PRU 9.2.18 R (for a firm holding client money or other client assets), it must hold additional capital as calculated in PRU 9.2.21 R or PRU 9.2.22 R (as appropriate).

31/10/2004

PRU 9.2.21

Table: Calculation of additional capital for firm not holding client money or other client assets (?000's)

Income

Excess obtained up to and including:

More than

Up to

2.5

100

150

200+

100

200

300

400

500

600

100

600

700

104

700

800

107

800

900

109

900

1,000

111

1,000

1,500

118

1,500

2,000

121

2,000

2,500

126

2,500

3,000

101

130

3,000

3,500

101

132

3,500

4,000

101

133

4,000

4,500

101

134

4,500

5,000

134

5,000

6,000

133

6,000

7,000

131

7,000

8,000

126

8,000

9,000

120

9,000

10,000

113

10,000

100,000

n/a

31/10/2004

PRU 9.2.22

Table: Calculation of additional capital for firm holding client money or other client assets (?000's)

Income

Excess obtained up to and including:

More than

Up to

100

150

200+

100

200

300

400

500

600

700

800

900

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

6,000

7,000

8,000

9,000

10,000

100,000

n/a

31/10/2004

PRU 9.2.23

PRU 9.3.52 R sets out the items which are eligible to contribute to the capital resources of a firm for the purposes of PRU 9.2.20 R.

31/10/2004

PRU 9.3

Capital resources for insurance and mortgage mediation activity and mortgage lending and administration

01/12/2004

Application

PRU 9.3.1

(1) This section applies to a firm with Part IV permission to carry on any of the activities in (2) unless any of PRU 9.3.4 R to PRU 9.3.11 R applies.
(2) The activities are:

(a) insurance mediation activity;
(b) mortgage mediation activity;
(c) entering into a regulated mortgage contract (that is, mortgage lending);
(d) administering a regulated mortgage contract (that is, mortgage administration).

31/10/2004

PRU 9.3.2

As this section applies only to a firm with Part IV permission, it does not apply to an incoming EEA firm (unless it has a top-up permission). An incoming EEA firm includes a firm which is passporting into the United Kingdom under the IMD (see AUTH 5.4.2 G, in relation to branches, and AUTH 5.5.3 G, in relation to cross border services).

31/10/2004

PRU 9.3.3

The definition of insurance mediation activity refers to several activities 'in relation to a contract of insurance' which includes a contract of reinsurance. This section, therefore, applies to a reinsurance intermediary in the same way as it applies to any other insurance intermediary.

31/10/2004

Application: banks, building societies, insurers and friendly societies

PRU 9.3.4

This section does not apply to:

(1) a bank; or
(2) a building society; or
(3) a solo consolidated subsidiary of a bank or a building society; or
(4) an insurer; or
(5) a friendly society.

31/10/2004

PRU 9.3.5

The capital resources of firms within PRU 9.3.4 R are calculated in accordance with the appropriate IPRU.

31/10/2004

Application: firms carrying on designated investment business only

PRU 9.3.6

This section does not apply to a firm whose Part IV permission is limited to regulated activities which are designated investment business.

31/10/2004

PRU 9.3.7

A firm which carries on designated investment business, and no other regulated activity, may disregard this section. For example, a firm with permission limited to dealing in investments as agent in relation to securities is only carrying on designated investment business and IPRU(INV) will apply. However, if its permission is varied to enable it to arrange motor insurance as well, this activity is not designated investment business so the firm will be subject to the higher of the requirements in this section and IPRU(INV) (see PRU 9.3.24 R).

31/10/2004

Application: credit unions

PRU 9.3.8

This section does not apply to:

(1) a 'small credit union', that is one with:

(a) assets of ?5 million or less; and
(b) a total number of members of 5,000 or less (see CRED 8.3.14 R); or

(2) a credit union whose Part IV permission includes mortgage lending or mortgage administration (or both) and no other activities in PRU 9.3.1 R (2).

31/10/2004

PRU 9.3.9

(1) For credit unions to which this section applies and which are not CTF providers, the capital requirements will be the higher of the requirements in this section and in CRED (see PRU 9.3.25 R).
(2) For credit unions to which this section applies and which are CTF providers with permission to carry on designated investment business, the capital requirements will be the highest of the requirements in this section, those in CRED and of IPRU(INV) Chapter 8 (see PRU 9.3.25 R).

01/12/2004

Application: professional firms

PRU 9.3.10

(1) This section does not apply to an authorised professional firm:

(a) whose main business is the practice of its profession; and
(b) whose regulated activities in PRU 9.3.1 R (2) are incidental to its main business.

(2) A firm's main business is the practice of its profession if the proportion of income it derives from professional fees is, during its annual accounting period, at least 50% of the firm's total income (a temporary variation of not more than 5% may be disregarded for this purpose).
(3) Professional fees are fees, commissions and other receipts receivable in respect of legal, accountancy or actuarial services provided to clients but excluding any items receivable in respect of regulated activities.

31/10/2004

Application: Lloyd's managing agents

PRU 9.3.11

This section does not apply to a managing agent.

31/10/2004

PRU 9.3.12

The reason for excluding managing agents from the provisions of this section is twofold: first, a member will have accepted full responsibility for those activities under the Society's managing agent agreement. Secondly, the member is itself subject to capital requirements which are equivalent to those applying to an insurer (to which this section is also disapplied - see PRU 9.3.4 R (4)).

31/10/2004

Application: social housing firms

PRU 9.3.13

There are special provisions for a social housing firm when it is carrying on mortgage lending or mortgage administration (see PRU 9.3.26 R).

31/10/2004

Purpose

PRU 9.3.14

This section amplifies threshold condition 4 (Adequate resources) by providing that a firm must meet, on a continuing basis, a basic solvency requirement (PRU 9.3.20 R) and a minimum capital resources requirement (PRU 9.3.21 R). This section also amplifies Principle 4 which requires a firm to maintain adequate financial resources by setting out capital requirements for a firm according to the regulated activity or activities it carries on.

31/10/2004

PRU 9.3.15

Capital has an important role to play in protecting consumers and complements the roles played by professional indemnity insurance (see PRU 9.2 (Professional indemnity insurance)) and client money protection (see the client money rules including, in particular, those in CASS 5 (Client money and mandates: insurance mediation activity)). Capital provides a form of protection for situations not covered by a firm's professional indemnity insurance and it provides the funds for the firm's PII excess, which it has to pay out of its own finances. The relationship between the firm's capital and its excess is set out in PRU 9.2.17 R.

31/10/2004

PRU 9.3.16

More generally, having adequate capital gives the firm a degree of resilience and some indication to consumers of creditworthiness, substance and the commitment of its owners. It reduces the possibility of a shortfall of funds and provides a cushion against disruption if the firm ceases to trade.

31/10/2004

PRU 9.3.17

There is a greater risk to consumers, and a greater adverse impact on market confidence, if a firm holding client money or other client assets fails. For this reason, the capital resources rules in this section clearly distinguish between firms holding client assets and those that do not.

31/10/2004

Purpose: social housing firms

PRU 9.3.18

Social housing firms undertake small amounts of mortgage business even though their main business consists of activities other than regulated activities. Their mortgage lending is only done as an adjunct to their primary purpose (usually the provision of housing) and is substantially different in character to that done by commercial lenders. Furthermore, they are subsidiaries of local authorities or registered social landlords which are already subject to separate regulation. The FSA does not consider that it would be proportionate to the risks involved with such business to impose significant capital requirements for these firms. PRU 9.3.26 R therefore simply provides that, where their Part IV permission is limited to mortgage lending and mortgage administration, their net tangible assets must be greater than zero.

31/10/2004

PRU 9.3.19

A registered social landlord is a non-profit organisation which provides and manages homes for rent and sale for people who might not otherwise be able to rent or buy on the open market. It can be a housing association, a housing society or a non-profit making housing company. The Housing Corporation, which was set up by Parliament in 1964, funds homes built by registered social landlords from money received from central government.

31/10/2004

Capital resources: general rules

PRU 9.3.20

A firm must at all times ensure that it is able to meet its liabilities as they fall due.

31/10/2004

PRU 9.3.21

A firm must at all times maintain capital resources equal to or in excess of its relevant capital resources requirement.

31/10/2004

Capital resources: relevant accounting principles

PRU 9.3.22

A firm must recognise an asset or liability, and measure its amount, in accordance with the relevant accounting principles applicable to it for the purpose of preparing its annual financial statements unless a rule requires otherwise.

21/04/2005
Past version of PRU 9.3.22 before 21/04/2005

Capital resources: client assets

PRU 9.3.23

In this section, "client assets" includes a document only if it has value, or is capable of having value, in itself (such as a bearer instrument).

31/10/2004

Capital resources requirement: firms carrying on regulated activities including designated investment business

PRU 9.3.24

The capital resources requirement for a firm (other than a credit union) carrying on regulated activities, including designated investment business, is the higher of:

(1) the requirement which is applied by this section according to the activity or activities of the firm (treating the relevant rules as applying to the firm by disregarding its designated investment business); and
(2) the financial resource requirement which is applied by IPRU(INV).

01/12/2004

Capital resources requirement: credit unions

PRU 9.3.25

The capital resources requirement for a credit union to which this section applies (see PRU 9.3.8 R) is the highest of:

(1) the requirement which is applied by PRU 9.3.30 R (Capital resources requirement: mediation activity only) treating that rule as applying to the credit union by disregarding activities which are not insurance mediation activity or mortgage mediation activity;
(2) the amount which is applied by CRED 8 (Capital requirements); and
(3) if the credit union is a CTF provider that has a permission to carry on designated investment business, the amount which is applied by IPRU(INV) Chapter 8.

01/12/2004

Capital resources requirement: social housing firms

PRU 9.3.26

The capital resources requirement for a social housing firm whose Part IV permission is limited to carrying on the regulated activities of:

(1) mortgage lender; or
(2) mortgage administration (or both);

is that the firm's net tangible assets must be greater than zero.

31/10/2004

PRU 9.3.27

If a social housing firm is carrying on mortgage lending or mortgage administration (and no other regulated activity), its net tangible assets must be greater than zero. However, if it carries on insurance mediation activity, or mortgage mediation activity, there is no special provision and PRU 9.3.24 R or PRU 9.3.30 R applies to it as appropriate.

31/10/2004

Capital resources requirement: application according to regulated activities

PRU 9.3.28

Unless any of PRU 9.3.24 R to PRU 9.3.26 R applies (firms carrying on designated investment business, credit unions and social housing firms), the table in PRU 9.3.29 R specifies the provisions for calculating the capital resources requirement for a firm according to the regulated activity or activities it carries on.

31/10/2004

PRU 9.3.29

Table: Application of capital resources requirements

Regulated activities

Provisions

(a) insurance mediation activity; or
(b) mortgage mediation activity (or both);

and no other regulated activity.

PRU 9.3.30 R

(a) mortgage lending; or
(b) mortgage lending and mortgage administration;

and no other regulated activity.

PRU 9.3.31 R to PRU 9.3.36 E

mortgage administration;
and no other regulated activity.

PRU 9.3.37 R to PRU 9.3.38 R

insurance mediation activity; and

(a)mortgage lending; or
(b)mortgage administration (or both).

PRU 9.3.39 R

mortgage mediation activity; and

(a)mortgage lending, or
(b)mortgage administration (or both).

PRU 9.3.40 R

Any combination of regulated activities not within rows 1 to 5.

PRU 9.3.41 R

31/10/2004

Capital resources requirement: mediation activity only

PRU 9.3.30

(1) If a firm (carrying on the activities in row 1 of the table in PRU 9.3.29 R) does not hold client money or other client assets in relation to its insurance mediation activity or mortgage mediation activity, its capital resources requirement is the higher of:

(a) ?5,000; and
(b) 2.5% of the annual income (see PRU 9.3.42 R) from its insurance mediation activity or mortgage mediation activity (or both).

(2) If a firm (carrying on the activities in row 1 of the table in PRU 9.3.29 R) holds client money or other client assets in relation to its insurance mediation activity or mortgage mediation activity, its capital resources requirement is the higher of:

(a) ?10,000; and
(b) 5% of the annual income (see PRU 9.3.42 R) from its insurance mediation activity or mortgage mediation activity (or both).

31/10/2004

Capital resources requirement: mortgage lending and administration (but not mortgage administration only)

PRU 9.3.31

(1) The capital resources requirement of a firm (carrying on the activities in row 2 of the table at PRU 9.3.29 R) is the higher of:

(a) ?100,000; and
(b) 1% of:

(i) its total assets plus total undrawn commitments; less:
(ii) loans excluded by PRU 9.3.33 R plus intangible assets (see Note 1 in the table in PRU 9.3.53 R).

(2) Undrawn commitments in (1)(b)(i) means the total of those amounts which a borrower has the right to draw down from the firm but which have not yet been drawn down, excluding those under an agreement:

(a) which has an original maturity of up to one year; or
(b) which can be unconditionally cancelled at any time by the lender.

31/10/2004

PRU 9.3.32

When considering what is an undrawn commitment, the FSA takes into account an amount which a borrower has the right to draw down, but which has not yet been drawn down, whether the commitment is revocable or irrevocable, conditional or unconditional.

31/10/2004

PRU 9.3.33

When calculating total assets for the purposes of PRU 9.3.31 R, the firm may exclude a loan which has been transferred to a third party only if it meets the following conditions:

(1) the loan must have been transferred in a legally effective manner by one of the following means:

(a) novation; or
(b) legal or equitable assignment; or
(c) sub-participation; or
(d) declaration of trust; and

(2) the lender:

(a) retains no material economic interest in the loan; and
(b) has no material exposure to losses arising from it.

31/10/2004

PRU 9.3.34

(1) When seeking to rely on the condition in PRU 9.3.33 R (2), a firm should ensure that the loan qualifies for the 'linked presentation' accounting treatment under Financial Reporting Standard 5 (Reporting the substance of transactions) issued in April 1994, and amended in December 1994 and September 1998 (if applicable to the firm).
(2) Compliance with (1) may be relied upon as tending to establish compliance with PRU 9.3.33 R (2).

31/10/2004

PRU 9.3.35

PRU 9.3.34 E is aimed at those firms which report according to FRS 5. Other firms which report under other standards, including International Accounting Standards, need not adopt FRS 5 in order to meet the condition in PRU 9.3.33 R (2).

31/10/2004

PRU 9.3.36

(1) When seeking to rely on the condition in PRU 9.3.33 R (2), a firm should not provide material credit enhancement in respect of the loan unless it deducts the amount of the credit enhancement from its capital resources before meeting its capital resources requirement.
(2) Credit enhancement includes:

(a) any holding of subordinated loans or notes in a transferee that is a special purpose vehicle; or
(b) over collateralisation by transferring loans to a larger aggregate value than the securities to be issued; or
(c) any other arrangement with the transferee to cover a part of any subsequent losses arising from the transferred loan.

(3) Contravention of (1) may be relied upon as tending to establish contravention of PRU 9.3.33 R (2).

31/10/2004

Capital resources requirement: mortgage administration only

PRU 9.3.37

The capital resources requirement of a firm (carrying on the activities in row 3 of the table in PRU 9.3.29 R), which has all or part of the regulated mortgage contracts that it administers on its balance sheet, is the amount which is applied to a firm by PRU 9.3.31 R.

31/10/2004

PRU 9.3.38

The capital resources requirement of a firm (carrying on the activities in row 3 of the table in PRU 9.3.29 R), which has all the regulated mortgage contracts that it administers off its balance sheet, is the higher of:

(1) £100,000; and
(2) 10% of its annual income (see PRU 9.3.42 R and PRU 9.3.48 R).

31/10/2004

Capital resources requirement: insurance mediation activity and mortgage lending or mortgage administration

PRU 9.3.39

The capital resources requirement for a firm (carrying on the activities in row 4 of the table in PRU 9.3.29 R) is the sum of the requirements which are applied to the firm by:

(1) PRU 9.3.30 R; and
(2)

(a) PRU 9.3.31 R; or
(b) if, in addition to its insurance mediation activity, the firm carries on only mortgage administration and has all the assets that it administers off balance sheet, PRU 9.3.38 R.

31/10/2004

Capital resources requirement: mortgage mediation activity and mortgage lending or mortgage administration

PRU 9.3.40

(1) If a firm (carrying on the activities in row 5 of the table in PRU 9.3.29 R) does not hold client money or other client assets in relation to its mortgage mediation activity, the capital requirement is the amount applied to a firm, according to the activities carried on by the firm, by:

(a) PRU 9.3.31 R; or
(b) if, in addition to its mortgage mediation activity, the firm carries on only mortgage administration and has all the assets that it administers off balance sheet, PRU 9.3.38 R.

(2) If a firm (carrying on the activities in row 5 of the table in PRU 9.3.29 R) holds client money or other client assets in relation to its mortgage mediation activity, the capital resources requirement is:

(a) the amount calculated under (1); plus
(b) the amount which is applied to a firm by PRU 9.3.30 R (2).

31/10/2004

Capital resources requirement: other combinations of activities

PRU 9.3.41

The capital resources requirement for a firm (carrying on the activities in row 6 of the table in PRU 9.3.29 R) is the amount which is applied to a firm by PRU 9.3.39 R.

31/10/2004

Annual income

PRU 9.3.42

PRU 9.3.43 R to PRU 9.3.50 R contain provisions relating to the calculation of annual income for the purposes of:

(1) PRU 9.2.13 R (2), PRU 9.2.15 R, PRU 9.2.17 R (2) and PRU 9.2.18 R (2) (all concerning the limits of indemnity for professional indemnity insurance); and
(2) PRU 9.3.30 R (1)(b) and PRU 9.3.30 R (2)(b), and PRU 9.3.38 R (2).

31/10/2004

PRU 9.3.43

'Annual income' is the annual income given in the firm's most recent annual financial statement from the relevant regulated activity or activities.

31/10/2004

PRU 9.3.44

For a firm which carries on insurance mediation activity or mortgage mediation activity, annual income in PRU 9.3.43 R is the amount of all brokerage, fees, commissions and other related income (for example, administration charges, overriders, profit shares) due to the firm in respect of or in relation to those activities.

31/10/2004

PRU 9.3.45

(1) The purpose of PRU 9.3.44 R is to ensure that the capital resources requirement is calculated on the basis only of brokerage and other amounts earned by a firm which are its own income.
(2) For the purposes of PRU 9.3.43 R and PRU 9.3.44 R, a firm's annual income includes commissions and other amounts the firm may have agreed to pay to other persons involved in a transaction, such as sub-agents or other intermediaries.
(3) A firm's annual income does not, however, include any amounts due to another person (for example, the product provider) which the firm has collected on behalf of that other person.

14/01/2005
Past version of PRU 9.3.45 before 14/01/2005

PRU 9.3.46

If a firm is a principal, its annual income includes amounts due to its appointed representative in respect of activities for which the firm has accepted responsibility.

31/10/2004

PRU 9.3.47

If a firm is a network, it should include the relevant income due to all of its appointed representatives in its annual income.

31/10/2004

Annual income for mortgage administration

PRU 9.3.48

For the purposes of PRU 9.3.38 R (2) (Mortgage administration only) annual income is the sum of:

(1) revenue (that is, commissions, fees, net interest income, dividends, royalties and rent); and
(2) gains;
(3) arising in the course of the ordinary activities of the firm, less profit:

(a) on the sale or termination of an operation;
(b) arising from a fundamental reorganisation or restructuring having a material effect on the nature and focus of the firm's operation; and
(c) on the disposal of fixed assets, including investments held in a long-term portfolio.

31/10/2004

Annual income: periods of less than 12 months

PRU 9.3.49

If the firm's most recent annual financial statement does not cover a 12 month period, the annual income is taken to be the amount in the statement converted, proportionally, to a 12 month period.

31/10/2004

Annual income: no financial statement

PRU 9.3.50

If the firm does not have an annual financial statement, the annual income is to be taken from the forecast or other appropriate accounts which the firm has submitted to the FSA.

31/10/2004

The calculation of a firm's capital resources

PRU 9.3.51

(1) A firm must calculate its capital resources only from the items in PRU 9.3.52 R from which it must deduct the items in PRU 9.3.53 R.
(2) If the firm is subject to IPRU(INV) or CRED, the capital resources are the higher of:

(a) the amount calculated under (1); and
(b) the financial resources calculated under IPRU(INV) or the capital calculated under CRED 8 (Capital requirements).

31/10/2004

PRU 9.3.52

Table: Items which are eligible to contribute to the capital resources of a firm

Item

Additional explanation

Share capital

This must be fully paid and may include:

(1)

ordinary share capital; or

(2)

preference share capital (excluding preference shares redeemable by shareholders within two years).

Capital other than share capital (for example, the capital of a sole trader, partnership or limited liability partnership)

The capital of a sole trader is the net balance on the firm's capital account and current account.
The capital of a partnership is the capital made up of the partners':

(1)

capital account, that is the account:

(a)

into which capital contributed by the partners is paid; and

(b)

from which, under the terms of the partnership agreement, an amount representing capital may be withdrawn by a partner only if:

(i)

he ceases to be a partner and an equal amount is transferred to another such account by his former partners or any person replacing him as their partner; or

(ii)

the partnership is otherwise dissolved or wound up; and

(2)

current accounts according to the most recent financial statement.

For the purpose of the calculation of capital resources, in respect of a defined benefit occupational pension scheme:

(1)

a firm must derecognise any defined benefit asset;

(2)

a firm may substitute for a defined benefit liability the firm's deficit reduction amount, provided that the election is applied consistently in respect of any one financial year.

Audited reserves

These are the audited accumulated profits retained by the firm (after deduction of tax, dividends and proprietors' or partners' drawings) and other reserves created by appropriations of share premiums and similar realised appropriations. Reserves also include gifts of capital, for example, from a parent undertaking.

For the purposes of calculating capital resources, a firm must make the following adjustments to its audited reserves, where appropriate:

(1)

a firm must deduct any unrealised gains or, where applicable, add back in any unrealised losses on debt instruments held in the available-for-sale financial assets category;

(2)

a firm must deduct any unrealised gains or, where applicable, add back in any unrealised losses on cash flow hedges of financial instruments measured at cost or amortised cost;

(3)

in respect of a defined benefit occupational pension scheme:

(a)

a firm must derecognise any defined benefit asset;

(b)

a firm may substitute for a defined benefit liability the firm's deficit reduction amount, provided that the election is applied consistently in respect of any one financial year.

Interim net profits

If a firm seeks to include interim net profits in the calculation of its capital resources, the profits have to be verified by the firm's external auditor, net of tax, anticipated dividends or proprietors' drawings and other appropriations.

Revaluation reserves

General/collective provisions

These are provisions that a firm carrying on mortgage lending or mortgage administration holds against potential losses that have not yet been identified but which experience indicates are present in the firm's portfolio of assets. Such provisions must be freely available to meet these unidentified losses wherever they arise. General/collective provisions must be verified by external auditors and disclosed in the firm's annual report and accounts.

Subordinated loans

Subordinated loans must be included in capital on the basis of the provisions in PRU 9.3.56 R and PRU 9.3.57 R.

21/04/2005
Past version of PRU 9.3.52 before 21/04/2005

PRU 9.3.52A

21/04/2005

PRU 9.3.53

Table: Items which must be deducted from capital resources

Investments in own shares

Intangible assets (Note 1)

Interim net losses (Note 2)

Excess of drawings over profits for a sole trader or a partnership (Note 2)

Notes
1. Intangible assets are the full balance sheet value of goodwill (but not until 14 January 2008 - see transitional provision 2), capitalised development costs, brand names, trademarks and similar rights and licences.
2. The interim net losses in row 3, and the excess of drawings in row 4, are in relation to the period following the date as at which the capital resources are being computed.

31/10/2004

Personal assets

PRU 9.3.54

In relation to a sole trader's firm or a firm which is a partnership, the sole trader or a partner in the firm may use personal assets to meet the requirements of PRU 9.3.20 R or PRU 9.3.21 R, or both, to the extent necessary to make up any shortfall in meeting those requirements, unless:

(1) those assets are needed to meet other liabilities arising from:

(a) personal activities; or
(b) another business activity not regulated by the FSA; or

(2) the firm holds client money or other client assets.

31/10/2004

PRU 9.3.55

The purpose of PRU 9.3.54 R is to enable a sole trader or a partner to use any personal assets, including property, to meet the capital requirements of this section, but only to the extent necessary to make up a shortfall. The requirements are the solvency requirement (PRU 9.3.20 R) and the capital resources requirement (PRU 9.3.21 R).

31/10/2004

Subordinated loans

PRU 9.3.56

In row 7 in the table at PRU 9.3.52 R, subordinated debt must not form part of the capital resources of the firm unless it meets the following conditions:

(1) (for a firm which carries on insurance mediation activity or mortgage mediation activity (or both) but not mortgage lending or mortgage administration) it has an original maturity of:

(a) at least two years; or
(b) it is subject to two years' notice of repayment;

(2) (for all other firms) it has an original maturity of:

(a) at least five years; or
(b) it is subject to five years' notice of repayment;

(3) the claims of the subordinated creditors must rank behind those of all unsubordinated creditors;
(4) the only events of default must be non-payment of any interest or principal under the debt agreement or the winding up of the firm;
(5) the remedies available to the subordinated creditor in the event of non-payment or other default in respect of the subordinated debt must be limited to petitioning for the winding up of the firm or proving the debt and claiming in the liquidation of the firm;
(6) the subordinated debt must not become due and payable before its stated final maturity date except on an event of default complying with (4);
(7) the agreement and the debt are governed by the law of England and Wales, or of Scotland or of Northern Ireland;
(8) to the fullest extent permitted under the rules of the relevant jurisdiction, creditors must waive their right to set off amounts they owe the firm against subordinated amounts owed to them by the firm;
(9) the terms of the subordinated debt must be set out in a written agreement or instrument that contains terms that provide for the conditions set out in (1) to (8); and
(10) the debt must be unsecured and fully paid up.

31/10/2004

PRU 9.3.57

(1) This rule applies to a firm which:

(a) carries on:

(i) insurance mediation activity; or
(ii) mortgage mediation activity (or both); and

(b) in relation to those activities, holds client money or other client assets;

but is not carrying on mortgage lending or mortgage administration.
(2) In calculating its capital resources under PRU 9.3.51 R (1), the firm must exclude any amount by which the aggregate amount of its subordinated loans and its redeemable preference shares exceeds the amount calculated under (3).
(3) The calculation for (2) is:

four times (a - b - c);
where
a = items 1 to 5 in the Table at PRU 9.3.52 R
b = the firm's redeemable preference shares; and
c = the amount of its intangible assets (but not goodwill until 14 January 2008 - see transitional provision 2).

31/10/2004

PRU 9.3.58

If a firm wishes to see an example of a subordinated loan agreement which would meet the conditions in PRU 9.3.56 R, it should refer to the Forms page.

31/10/2004

PRU 9.4

Insurance undertakings and mortgage lenders using insurance or mortgage mediation services

01/12/2004

Application

PRU 9.4.1

This section applies to a firm with a Part IV permission to carry on:

(1) insurance business; or
(2) mortgage lending;
(3) and which uses, or proposes to use, the services of another person consisting of:

(a) insurance mediation; or
(b) insurance mediation activity; or
(c) mortgage mediation activity.

31/10/2004

Purpose

PRU 9.4.2

The purpose of PRU 9.4 is to implement article 3.6 of the Insurance Mediation Directive in relation to insurance undertakings. The provisions of this section have been extended to mortgage lenders in relation to insurance mediation activity, and to insurance undertakings and mortgage lenders in relation to mortgage mediation activity, to ensure that firms using these services are treated in the same way and to ensure that clients have the same protection. To avoid the loss of protection where an intermediary itself uses the services of an unauthorised person, PRU 9.4.4 R has the effect of ensuring that each person in the chain of those providing services is authorised.

31/10/2004

PRU 9.4.3

PRU 9.4 supports the more general duties in Principles 2 and 3, and SYSC 3.1.1 R.

31/10/2004

Use of intermediaries

PRU 9.4.4

A firm must not use, or propose to use, the services of another person consisting of:

(1) insurance mediation; or
(2) insurance mediation activity; or
(3) mortgage mediation activity;

unless the conditions in PRU 9.4.5 R and PRU 9.4.7 R are satisfied.

31/10/2004

PRU 9.4.5

The first condition in PRU 9.4.4 R is that the person, in relation to the activity:

(1) has permission; or
(2) is an exempt person; or
(3) is an exempt professional firm; or
(4) is registered in another EEA State for the purposes of the IMD; or
(5) in relation to insurance mediation activity, is not carrying this activity on in the EEA; or
(6) in relation to mortgage mediation activity, is not carrying this activity on in the United Kingdom.

31/10/2004

PRU 9.4.6

(1) A firm should:

(a) before using the services of the intermediary, check:

(i) the FSA Register; or
(ii) in relation to insurance mediation carried on by an EEA firm, the register of its Home State regulator;

for the status of the person; and
(b) use the services of that person only if the relevant register indicates that the person is registered for that purpose.

(a) Compliance with (1)(a)(i) and (b) may be relied on as tending to establish compliance with:

(i) PRU 9.4.5 R (1); or
(ii) in relation to insurance mediation activity, also PRU 9.4.5 R (2) and PRU 9.4.5R (3).

(b) Compliance with (1)(a)(ii) and (b) may be relied on as tending to establish compliance with PRU 9.4.5 R (4).

31/10/2004

PRU 9.4.7

The second condition in PRU 9.4.4 R is that the firm takes all reasonable steps to ensure that the person in PRU 9.4.5 R in relation to the activity, is not, directly or indirectly, carrying out the activity as a consequence of the activities of another person which:

(1) contravene section 19 of the Act (The general prohibition); or
(2) in the case of activities provided from an establishment in an EEA State, contravene the IMD registration requirements.

14/01/2005
Past version of PRU 9.4.7 before 14/01/2005

PRU 9.4.8

In order to comply with PRU 9.4.7 R, a firm may rely on a confirmation provided by the other person in writing if:

(1) the confirmation is provided by a person within PRU 9.4.5 R;
(2) the firm checked that this is the case; and
(3) the firm is not aware that the confirmation is inaccurate and has no grounds for reasonably being aware that the confirmation is inaccurate.

31/10/2004

PRU 9.4.9

The FSA Register can be accessed through the FSA website under the link www.fsa.gov.uk/register.

31/10/2004

PRU 9 Annex 1

Example of the application of PRU 9.1.3 R, PRU 9.1.4 R, PRU 9.1.8 R and PRU 9.1.10 R

01/12/2004

31/10/2004

Export chapter as

Legal Instruments that change this Chapter Insurance mediation

Transitional Provisions and Schedules

PRU TP 1

Transitional Provisions

PRU TP 1.1

Transitional Provisions

(1)

(2)

(3)

(4)

(5)

(6)

Material to which the transitional provision applies

Transitional provision

Transitional provision: dates in force

Handbook provision: coming into force

PRU 9.2.7 R

PRU 9.2.7 R (Requirement to hold professional indemnity insurance) does not apply in respect of acts or omissions occurring before:
(1) 31 October 2004 (in relation to mortgage mediation activity); and
(2) 14 January 2005 (in relation to insurance mediation activity).

From 31 October 2004

31 October 2004

PRU 9.3.53 R and PRU 9.3.57R (3)

A firm is not required to include goodwill in its intangible assets until 14 January 2008.

From 31 October 2004 until 14 January 2008

31 October 2004

[deleted]

Rules in PRU listed in the Table at PRU TR Table 10R

(1) A rule listed in column (2) is disapplied, or is modified in its application, to a firm;
(a) in order to produce the same effect, including any conditions, as a waiver had on the corresponding rule in IPRU(INS);
(b) for the same period as the waiver would have lasted, if shorter than the period in column (5);
provided the conditions set out in (2) are satisfied.
(2) The conditions referred to in (1) are:
(a) the rule is shown in the Table at PRU TR Table 10R as corresponding with the rule in IPRU(INS) in relation to which the waiver was granted to the firm;
(b) the waiver was current as respects the firm immediately before the date specified in column (6); and
(c) there is no specific transitional rule relating to the waiver.
(3) (1) does not have effect if, and to the extent that, it would be inconsistent with any community obligation of the United Kingdom.

From 31 December 2004 until the relevant rule is revoked

31 December 2004

PRU 9.4.5 R and PRU 9.4.7 R

PRU 9.4.5 R and PRU 9.4.7 R have effect in respect of the use by a firm of the services of another person consisting of insurance mediation and provided from an establishment in an EEA State that has not implemented Article 3 (Registration) of the IMD, as if the condition in paragraph (4) of PRU 9.4.5 R and the condition in paragraph (2) of PRU 9.4.7 R were a condition that the firm has no reason to doubt the good repute, competence and financial standing of that person.

14 January 2005 to 14 January 2006

14 January 2005

Rules in PRU not listed in the Table at PRU TR Table 10R

(1) A rule listed in column (2) is disapplied, or is modified in its application, to a firm:
(a) in order to produce the same effect, including any conditions, as a waiver had on a rule in IPRU(INS) or IPRU(FSOC), or a written concession had on a pre-commencement provision listed in PRU TR 7R;
(b) for the same period as the waiver or written concession would have lasted, if shorter than the period in column (5); provided the conditions set out in (2) are satisfied.
(2) The conditions referred to in (1) are:
(a) the rule in PRU is substantially similar to the rule in IPRU(INS), IPRU(FSOC), or the pre-commencement provision, as the case may be, with which the waiver or written concession was concerned;
(b) the waiver or written concession was current as respects the firm immediately before the date specified in column (6);
(c) there is no specific transitional rule relating to the waiver or written concession; and
(d) in the case of a written concession, it has not been superseded by a waiver from the FSA.
(3) (1) does not have effect if, and to the extent that, it would be inconsistent with any community obligation of the United Kingdom.

From 31 December 2004 until 30 June 2005

31 December 2004

As PRU TR 6R

The pre-commencement provisions referred to in these transitional provisions are those contained in:
(1) the Insurance Companies Act 1982 and relevant secondary legislation;
(2) the Friendly Societies Act 1992 and relevant secondary legislation.

As PRU TR 6R

As PRU TR 5R to PRU TR 7R

A firm which has the benefit of a waiver to which PRU TR 5R applies, or a waiver or written concession to which PRU TR 6R applies, must:
(1) notify the FSA immediately if it becomes aware of any matter which is material to the relevance or appropriateness of the waiver or written concession;
(2) maintain a written record of the rule in PRU to which it considers the waiver or written concession applies; and
(3) make the record available to the FSA on request.

As PRU TR 5R or PRU TR 6R

As PRU TR 6R

PRU TR 5R to PRU TR 25R

In these transitional provisions:
(1) "substantially similar" means substantially similar in purpose and effect;
(2) "written concession" means a waiver, exemption, concession, modification, consent, approval, determination or similar exercise of discretion which:
(a) disapplied, or tended to reduce the burden of complying with, a pre-commencement provision (with or without conditions); and
(b) was evidenced in writing.

As PRU TR 5R or PRU TR 6R

31 December 2004

PRU TR Table 10R

This Table belongs to PRU TR 5R to PRU TR 9R

Rules in PRU

Corresponding rules in IPRU(INS)

1.3.35R

4.2 (3)

2.1.9R

2.9 (3)

2.1.21R

2.9

2.1.22R

2.9

2.1.30R

2.4 (6)

2.2.80R

2.10 (7)

2.2.81R

2.10 (7)

2.2.86R

4.14

4.5 (7)

3.2.22R

4.14 (1)

4.2.34R

5.11

4.2.39R

5.11

5.11 (4)

5.11 (5)

5.11 (9)

5.11 (11)

4.2.58R

2.3 (2)

7.2.51R

2.4 (6)

7.2.56R

2.4 (1)

7.2.66R

Appendix 2.1 2.4(1)(b)

Appendix 2.2 2.4(1)(b)

5.9 (1)

7.3.40R

5.9 (2)

7.3.41R

5.9 (2)

7.3.43R

5.10

7.3.74R

5.16

8.3.17R(1)(a)-(b)

10.1

10.2

10.2 (1)

10.2 (2)

10.2 (3)

8.3.23R

10.2

10.2 (1)

10.2 (2)

10.2 (3)

PRU TR

(1)

(2)

(3)

(4)

(5)

(6)

Material to which the transitional provision applies

Transitional provision

Transitional provision: dates in force

Handbook provision: coming into force

PRU 1.2
PRU 5.1

If a firm, as at 31 December 2004, has the benefit of a waiver of:
(1) SUP 16.7.10 R ; or
(2) SUP 16.7.12 R ;
under which the firm does not have to supply adequate information on mismatch liquidity, the provisions referred to in column (2) do not apply.

From 31 December 2004 until the date the waiver referred to in column (4) ceases to have effect.

31 December 2004

PRU 1.3.5 R
PRU 7.4.191 R

[deleted]

PRU 1.3.14R

A firm will be treated as complying with the rule listed in column (2) if it marks to market by reference to market value as determined in accordance with generally accepted accounting concepts, bases and policies or other generally accepted methods appropriate to insurers.

From 31 December 2004 to 30 December 2006

31 December 2004

PRU 1.3.31 R PRU 2.2.90 R

(1) A firm may elect to apply PRU 1.3.11 R to shares in a regulated related undertaking that is not an insurance undertaking or an insurance holding company.
(2) A firm may apply PRU 1.3.11 R if it has made the election referred to in sub-paragraph (1) by written notice to the FSA in a way which complies with the requirements for written notice in SUP 15.7.
(3) Where a firm has made the election referred to in (1):
(a) PRU 2.2.90 R is disapplied in respect of the shares in that regulated related undertaking; and
(b) the shares in that regulated related undertaking must be valued in accordance with (4).
(4) Subject to (5), the shares in the regulated related undertaking within (3) must be valued in accordance with PRU 1.3.11 R.
(5) For the purposes of valuing the shares in a regulated related undertaking within (4), the value of those shares determined in accordance with PRU 1.3.11 R must be reduced:
(a) by an approximate amount, to the extent that the value of those shares in the regulated related undertaking cannot effectively be realised to meet the capital resources requirement of the firm; and
(b) by an approximate amount, to exclude value attributable to goodwill generated from the business of the regulated related undertaking with other members of the insurance group.

From 31 December 2004 until the first day of the firm's financial year beginning in 2005

31 December 2004

As PRU TR 14R

(1) The application of PRU 1.3.31 R to a regulated related undertaking which is not an insurance undertaking or an insurance holding company implements the amendments to the First Non-Life Directive, the First Life Directive and the Insurance Groups Directive in Articles 22(2), 23(2) and 28(6) of the Financial Groups Directive.
(2) PRU TR 14R allows the requirement to treat a regulated related undertaking which is not an insurance undertaking or an insurance holding company in accordance with PRU 1.3.31 R to be postponed until the effective date of the Financial Groups Directive.
(3) In the interim, a firm may elect either to apply PRU 1.3.11 R or to value shares in a regulated related undertaking which is not an insurance undertaking or an insurance holding company in accordance with PRU 1.3.31 R. The intention is to allow firms to continue to account for the value of shares held in these regulated related undertakings as they would formerly have done under IPRU(INS) for the purposes of calculating the capital resources of a firm.

As PRU TR 14R

PRU 2.2.93R (3)
PRU 2.2.101R (3)
PRU 2.2.101R (4)
PRU 2.2.102 R
PRU 2.2.103 R
PRU 2.2.105 R

(1) This paragraph applies to a firm which immediately before the date specified in column (6) had the benefit of a waiver in relation to IPRU(INS) rule 2.10 or 5.2, or a written concession in relation to a pre-commencement provision listed in PRU TR 7R, in either case allowing the firm to exclude from the calculation of its liabilities obligations under a particular capital instrument issued by the firm.
(2) Subject to (3) and to compliance with the conditions set out in (4), a firm will be treated as complying with a rule listed in column (2) in relation to the capital instrument to which the waiver or written concession referred to in (1) related so long as the firm is not obliged to pay any interest under the terms of the capital instrument in circumstances where the firm does not have capital resources equal to or in excess of its required margin of solvency under the Insurance Directives.
(3) (2) ceases to apply to a firm:
(a) once the firm has redeemed the capital instrument; or
(b) on or after any date upon which the firm has the option to redeem the capital instrument and may prudently do so.
(4) The conditions referred to in (2) are:
(a) the firm must notify the FSA immediately if it becomes aware of any matter which is material to the relevance or appropriateness of the waiver or written concession;
(b) the firm must maintain a written record of the rule in PRU to which it considers the waiver or written concession applies; and
(c) the firm must make the record available to the FSA on request.

From 31 December 2004 until the relevant rule is revoked

31 December 2004

PRU 2.2.93R (2)

(1) This paragraph applies to a firm carrying on with-profits insurance business which immediately before the date specified in column (6) had the benefit of a waiver in relation to IPRU(INS) rule 2.10 or 5.2 or a written concession in relation to a pre-commencement provision listed in PRU TR 7R in either case allowing the firm to exclude from the calculation of its liabilities obligations under a particular capital instrument issued by the firm.
(2) Subject to compliance with the conditions set out in (3), PRU 2.2.93R (2) does not apply in relation to the capital instrument to which the waiver or written concession referred to in (1) related provided that capital instrument was issued by the firm on or before 30 December 2004.
(3) The conditions referred to in (2) are:
(a) the firm must notify the FSA immediately if it becomes aware of any matter which is material to the relevance or appropriateness of the waiver or written concession;
(b) the firm must maintain a written record of the rule in PRU to which it considers the waiver or written concession applies; and
(c) the firm must make the record available to the FSA on request.

From 31 December 2004 until 30 December 2005

31 December 2004

PRU 2.2.108R (5)
PRU 2.2.108R (7)

(1) This rule applies to a firm which immediately before the date specified in column (6) had the benefit of a waiver in relation to IPRU(INS) rule 2.10 or 5.2, or a written concession in relation to a pre-commencement provision listed in PRU TR 7R, in either case allowing the firm to exclude from the calculation of its liabilities obligations under a particular capital instrument issued by the firm.
(2) Subject to compliance with the conditions set out in (3), a firm will be treated as complying with a rule listed in column (2) in relation to the capital instrument to which the waiver or written concession referred to in (1) related.
(3) The conditions referred to in (2) are:
(a) the firm must notify the FSA immediately if it becomes aware of any matter which is material to the relevance or appropriateness of the waiver or written concession;
(b) the firm must maintain a written record of the rule in PRU to which it considers the waiver or written concession applies; and
(c) the firm must make the record available to the FSA on request.

From 31 December 2004 until 30 June 2005

31 December 2004

PRU 2.2.108R (6)
PRU 2.2.108R (10)
PRU 2.2.108R (11)
PRU 2.2.111 R

From 31 December 2004 until the relevant rule is revoked

31 December 2004

PRU 2.2.12 R
PRU 2.2.14 R
(Table)

(1) This rule applies to a firm which immediately before the date specified in column (6) had the benefit of a waiver in relation to IPRU(INS) rule 2.10 (4).
(2) For the period specified in column (5) or the same period as the waiver would have lasted if shorter, subject to (3) and to compliance with the conditions set out in (4), for the purposes of calculating its capital resources a firm may include the value of claims against its members by way of calls for supplementary contributions as core tier one capital to the same extent as it was permitted by the waiver to include the value of those claims in the calculation of its margin of solvency.
(3) (2) does not apply for the purposes of PRU 2.2.18 R or SUP App 2.4.
(4) The conditions referred to in (2) are:
(a) the limits specified in the waiver on the extent to which the firm's claim against its members by way of call for supplementary contributions may be brought into account apply as if the reference (if any) in the waiver to the firm's required margin of solvency referred to its general insurance capital requirement and the reference (if any) in the waiver to the firm's margin of solvency referred to its capital resources; and
(b) the firm must comply with any further conditions imposed by the waiver.

From 31 December 2004 until the relevant rule is revoked

31 December 2004

PRU 2.2.12 R
PRU 2.2.14 R
(Table)

(1) This rule applies to a firm which immediately before the date specified in column (6) had the benefit of a waiver in relation to IPRU(INS) rule 2.10 (5) or IPRU(FSOC) rule 4.7 (3).
(2) For the period specified in column (5) or the same period as the waiver would have lasted if shorter, subject to (3) and to compliance with the conditions set out in (4), for the purpose of calculating its capital resources a firm may include the value of implicit items at Stage B of the calculation in PRU 2.2.14 R Table to the same extent to which it was permitted by the waiver to include the value of those implicit items in the calculation of its margin of solvency.
(3) (2) does not apply for the purposes of PRU 2.2.17 R.
(4) The conditions referred to in (2) are:
(a) the limits specified in the waiver on the extent to which the value of implicit items may be brought into account apply as if the reference (if any) in the waiver to the firm's required margin of solvency referred to its minimum capital requirement and the reference (if any) in the waiver to the firm's margin of solvency referred to its capital resources; and
(b) the firm must comply with any further conditions imposed by the waiver.

From 31 December 2004 until the relevant rule is revoked

31 December 2004

PRU 2.1.21 R
PRU 2.1.30 R
PRU 2.2.18 R
PRU 3.2.22 R
PRU 7.2.51 R
PRU 7.2.85 R

In relation to any financial year starting on or before 30 December 2004, a firm's general insurance capital requirement or a firm's insurance health risk capital component is its margin of solvency calculated in accordance with:
(1) IPRU(INS) rule 2.4 (excluding 2.4(1)(a)) and Appendices 2.1 and 2.2, or IPRU(INS) rule 2.4 (excluding 2.4(1)(a)) and Appendices 2.1 and 2.2 (as applied by rule 2.7 to long-term insurance business of class IV); or
(2) APER 3.1.4 G (excluding 4.2(1)(a)) and Appendix 2 Parts I and II, or APER 3.1.4 G (excluding 4.2(1)(a)) and Appendix 2 Parts I and II, (as applied by paragraph 3 of Appendix I to long-term insurance business of class IV);
as the case may be, as those rules had effect immediately prior to the date in column (6).

From 31 December 2004 until the relevant rule is revoked

31 December 2004

PRU 4.3.5 R (3)(b)
PRU 4.3.34 R
PRU 4.3.35 R

(1) PRU 4.3.5 R (3)(b) has effect as if the words "and is capable of valuation" and "to 4.3.35R" were omitted.
(2) PRU 4.3.34 R has effect as if it read "For the purpose of PRU 4.3.5 R (3)(b), a transaction is on approved terms only if the firm reasonably believes that it may be readily closed out".
(3) PRU 4.3.35 R does not apply.

From 31 December 2004 until 30 December 2005

31 December 2004

PRU 7.5.20 R
PRU 7.5.45 R

In relation to any financial year starting on or before 30 December 2004:
(1) a firm's non-credit equalisation provision is its equalisation reserve in respect of Part II business carried on by the firm calculated in accordance with IPRU(INS) rules 6.4 to 6.10 and Appendix 6.1 as those rules had effect immediately prior to the date in column (6); and
(2) a firm's credit equalisation provision is its equalisation reserve in respect of credit insurance business carried on by the firm calculated in accordance with IPRU(INS) rules 6.11 to 6.12 and Appendix 6.2 as those rules had effect immediately prior to the date in column (6).

From 31 December 2004 until the relevant rule is revoked.

31 December 2004

PRU 8.3.8 R
PRU 8.3.9 R
PRU 8.3.10 R
PRU 8.3.15 R

(1) For the purpose of the calculation of the group capital resources and group capital resources requirement of an undertaking referred to in PRU 8.3.17 R, a firm may elect not to take a regulated related undertaking, which is not an insurance undertaking or an insurance holding company, into account in accordance with PRU 8.3.33 R and PRU 8.3.36 R.
(2) A firm may elect not to take a regulated related undertaking, which is not an insurance undertaking or an insurance holding company into account as referred to in (1), if it has made the election by written notice to the FSA in a way that complies with the requirements for written notice in SUP 15.7
(3) A firm that has made an election referred to in (2) must value that regulated related undertaking in accordance with (4) for the purpose of the calculation of the group capital resources and group capital resources requirement of an undertaking referred to in PRU 8.3.17 R.
(4) Subject to (5), a regulated related undertaking within (3) must, for the purposes of the calculations referred to in (1), be valued in accordance with PRU 1.3.11 R.
(5) For the purposes of valuing a regulated related undertaking within (3), the value of that regulated related undertaking determined in accordance with PRU 1.3.11 R, must be reduced:
(a) by an approximate amount, to the extent that the value of the regulated related undertaking cannot effectively be realised to meet the group capital resources requirement of an undertaking in PRU 8.3.17 R; and
(b) by an approximate amount, to the extent needed to exclude value attributable to goodwill generated from the business of the regulated related undertaking with other members of the insurance group.

From 31 December 2004 until the first day of the firm's financial year beginning in 2005

31 December 2004

As PRU TR 25R

(1) The inclusion of a regulated related undertaking which is not an insurance undertaking or an insurance holding company in the scope of application of PRU 8.3.33 R and PRU 8.3.36 R and implements the amendments to the First Non-Life Directive, the First Life Directive and the Insurance Groups Directive in Articles 22(2), 23(2) and 28(6) of the Financial Groups Directive.
(2) PRU TR 25R allows the requirement to include a regulated related undertaking which is not an insurance undertaking or an insurance holding company in the calculations required by Transitional Provisions to be postponed until the effective date of the Financial Groups Directive.
(3) In the interim, a firm may apply PRU 8.3, or elect to use the general valuation rules for related undertakings which do not fall within the scope of PRU 8.3, as set out in PRU 1.3.11 R, subject to the adjustments required by PRU TR 25R(5). The intention is to allow firms to continue to take the regulated related undertakings referred to in PRU TR 25R(1) and any other related undertaking not referred to in PRU 8.3 into account as they would formerly have done for the purposes of calculating the group capital resources of an undertaking in PRU 8.3.17 R.

As PRU TR 25R

21/04/2005
Past version of PRU TP 1 before 21/04/2005

PRU Sch 1

Record keeping requirements

31/12/2004

PRU Sch 1.1

1 The aim of the guidance in the following table is to give the reader a quick overall view of the relevant record keeping requirements.
2 It is not a complete statement of those requirements and should not be relied on as if it were.
3 Table

31/12/2004

Handbook reference

Subject of Record

Contents of record

When record must be made

Retention period

PRU 1.2.37 R, PRU 1.2.38 R

Firm's assessment of the adequacy of its financial resources

(1) The major sources of risk identified in accordance with PRU 1.2.31 R

(2) How the firm intends to deal with those risks

(3) Details of the stress tests and scenario analyses carried out and the resulting financial resources estimated to be required in accordance with PRU 1.2.35 R

Not specified

At least 3 years

PRU 1.4.53 R

Prudential risk management and systems and controls

Accounting and other records that are sufficient to enable the firm to demonstrate to the FSA:

(1) that the firm is financially sound and has appropriate systems and controls;

(2) the firm's financial position and exposure to risk (to a reasonable degree of accuracy);

(3) the firm's compliance with the rules in PRU

Not specified

3 years, or longer as appropriate

PRU 7.3.20 R

Mathematical reserves

(1) The methods and assumptions used in establishing the firm's mathematical reserves, including the margins for adverse deviation, and the reasons for their use

(2) The nature of, reasons for, and effect of, any change in approach, including the amount by which the change in approach increases or decreases its mathematical reserves

Not specified

An appropriate period

PRU 7.4.17 R, PRU 7.4.19 R

Calculation of with-profits insurance capital component

(1) The methods and assumptions used in making any calculation required for the purposes of PRU 7.4 (and any subsequent changes) and the reasons for their use

(2) Any change in practice (in particular changes in those items which will or may be significant in relation to the eventual claim values) and the nature of, reasons for, and effect of, any change in approach with respect to those methods and assumptions

Not specified

An appropriate period

PRU 7.6.23 R

Long-term insurance funds

A separate accounting record in respect of each of a firm's long-term insurance funds

Not specified

PRU 7.6.56 R, PRU 7.6.57 R

Branch accounting records in the United Kingdom

A record of the activities carried on from a non-EEA direct insurer's United Kingdom branch and, if it is an EEA-deposit insurer, from its branches in other EEA states including a record of:

(1) the income, expenditure and liabilities arising from activities of the branch or branches

(2) the assets identified under PRU 7.2.20 R as available to meet those liabilities

Not specified

31/12/2004

PRU Sch 2

Notification requirements

01/12/2004

PRU Sch 2.1

There are no notification requirements in PRU 1 or PRU 8. This Schedule does not cover any other chapter of PRU.1 The aim of the guidance in the following table is to give the reader a quick overall view of the relevant notification requirements.

11/08/2004

2 It is not a complete statement of those requirements and should not be relied on as if it were.

11/08/2004

3 Table

11/08/2004

Handbook reference

Matter to be notified

Contents of notification

Trigger event

Time allowed

PRU 2.1.38 R

Breach or expected breach of PRU 2.1.9 R

Fact of breach or expectation of breach

Breach or expectation of breach

Immediately

PRU 2.2.71 R

Intention to include any perpetual non-cumulative preference shares or innovative tier one instruments in the firm's tier one capital resources for the purposes of PRU 2.2

Fact of intention

Intention to include

At least one month before the firm first includes the relevant items in its tier one capital resources

PRU 2.2.72 R

Intention to redeem a tier one capital instrument that a firm has included in its tier one capital resources for the purpose of PRU 2.2

Fact of intention

Intention to redeem

At least one month before the intended redemption

PRU 2.2.116 R

Proposed amendment to the terms of the debt and the documents referred to in PRU 2.2.108R (8)

Details of the proposed amendment and confirmation that the legal opinions referred to in PRU 2.2.108R (11) and, if applicable, PRU 2.2.105 R and PRU 2.2.111 R, continue in full force and effect in relation to the terms of the debt and the documents notwithstanding any proposed amendment

Proposal to amend

At least one month before the amendment is due to take effect

PRU 2.2.117 R

Intention to repay a tier two instrument (unless the firm intends to repay an instrument on its contractual repayment date)

Fact of intention and details of how the firm will meet its capital resources requirement after such a repayment

Intention to repay

At least six months before the proposed date of repayment

PRU 3.2.23 R

That a reinsurance exposure to a reinsurer or group of closely related reinsurers is reasonably likely to exceed, or has exceeded, 100% of the firm's capital resources excluding capital resources held to cover property-linked liabilities

Fact that the limit is reasonably likely to be, or has been, exceeded

Note: upon notification under PRU 3.2.23 R the firm must:

(1) demonstrate that prudent provision has been made for the reinsurance exposure in excess of the 100% limit, or explain why in the opinion if the firm no provision is required, and

(2) explain how the reinsurance exposure if being safely managed (see PRU 3.2.24 R

(1) A reasonable likelihood that the limit will be exceeded, or

(2) if (1) does not apply , the limit being exceeded

As soon as the firm first becomes aware of the matter required to be notified

PRU 3.2.29 R

That the firm has exceeded, or anticipates exceeding, the limit expressed in PRU 3.2.28 E (in each financial year a firm should restrict the gross earned premiums which it pays to a reinsurer or group of closely related reinsurers to the higher of (a) 20% of the firm's projected gross earned premiums for that financial year and (b) ?4 million)

Fact that the limit has been exceeded, or that the firm anticipates exceeding the limit

Note: upon notification under PRU 3.2.29 R the firm must explain to the FSA how, despite the excess reinsurance concentration, the credit risk is being safely managed (see PRU 3.2.30 R)

The limit being exceeded, or an anticipation that the limit will be exceeded

Immediately

11/08/2004

PRU Sch 3

Fees and other required payments

31/12/2004

Notification Requirements

PRU PRI Sch 3.1

There are no requirements for fees or other payments in PRU 1 or PRU 8. This Schedule does not cover any other chapter of PRU.There are no requirements for fees or other payments in PRU.

31/12/2004

PRU Sch 4

Powers exercised

31/12/2004

Powers Exercised

PRU Sch 4.1

The following powers and related provisions in the Act have been exercised by the FSA to make the rules in PRU:

(1)

section 138 (General rule-making power);

(2)

section 141 (Insurance business rules);

(3)

section 149 (Evidential provisions);

(4)

section 150(2) (Actions for damages); and

(5)

section 156 (General supplementary powers).

31/12/2004

PRU Sch 4.2

The following power in the Act has been exercised by the FSA to give the guidance in PRU :

Section 157(1) (Guidance).

31/12/2004

PRU Sch 5

Rights of action for damages

01/12/2004

Rights of action for damages

PRU Sch 5.1

The table below sets out the rules in PRU contravention of which by an authorised person may be actionable under section 150 of the Act (Actions for damages) by a person who suffers loss as a result of the contravention.

11/08/2004

PRU Sch 5.2

If a "Yes" appears in the column headed "For private person", the rule may be actionable by a private person under section 150 (or, in certain circumstances, his fiduciary or representative; see article 6(2) and (3)(c) of the Financial Services and Markets Act 2000 (Rights of Action) Regulations 2001 (SI 2001/2256)). A "Yes" in the column headed "Removed" indicates that the FSA has removed the right of action under section 150(2) of the Act. If so, a reference to the rule in which it is removed is also given.

11/08/2004

PRU Sch 5.3

The column headed "For other person" indicates whether the rule may be actionable by a person other than a private person (or his fiduciary or representative) under article 6(2) and (3) of those Regulations. If so, an indication of the type of person by whom the rule may be actionable is given.

11/08/2004

PRU Sch 5.4

Chapter/Appendix

Section/Annex

Rights of action under section 150

For private person

Removed

For other person

All rules in PRU

Yes (PRU 1.8.1 R)

11/08/2004

PRU Sch 6

Rules that can be waived

31/12/2004

Rules that can be waived

PRU Sch 6.1

The rules in PRU can be waived by the FSA under section 148 of the Act (Modification or waiver of rules), except for PRU 1.8.1 R (actions for damages).

31/12/2004

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Application and general requirements

to follow

Adequacy of financial resources

Application

Purpose

Outline of other related provisions

Main Requirements

Stress tests and scenario analyses

Valuation

Application

Purpose

General requirements: accounting principles to be applied

Investments, derivatives and quasi-derivatives

Marking to market

Marking to model

Independent price verification

Valuation adjustments or reserves

Valuation adjustments or reserves

Shares in, and debts due from, related undertakings

Community co-insurance operations: general insurance business

Prudential risk management and associated systems and controls

Application

Purpose

How to interpret PRU 1.4

The role of systems and controls in a prudential context

The prudential responsibilities of senior management and the apportionment of those responsibilities

The delegation of responsibilities within the firm

Firms subject to risk management on a group basis

Business planning and risk management

Internal controls: introduction

Internal controls: segregation of duties

Internal controls: risk management committees

Internal controls: risk assessment

Internal audit

Management information

Record keeping

to follow

to follow

to follow

Actions for damages

Capital

Calculation of capital resources requirements

Application

Purpose

Main requirements

Calculation of the CRR

Calculation of the MCR

Calculation of the base capital resources requirement

Calculation of the general insurance capital requirement

Calculation of the long-term insurance capital requirement

Calculation of the ECR

Monitoring requirements

Capital resources

Application

Purpose

Principles underlying the definition of capital resources

Tier one capital

Upper and lower tier two capital

Deductions from capital

Calculation of capital resources

Limits on the use of different forms of capital

Characteristics of tier one capital

Core tier one capital: permanent share capital

Basic rules about redemption and cumulative coupons

Further guidance on redemption

Further guidance on coupons

Perpetual non-cumulative preference shares

Innovative tier one instruments: general rules

Innovative tier one instruments: loss absorbency

Innovative tier one instruments: Coupons

Innovative tier one instruments and other tier one instruments: step-ups

Innovative tier one instruments: principal stock settlement

Requirement to have sufficient unissued stock

Notifying the FSA of the issue and redemption of tier one instruments

Non standard capital instruments

Step-ups